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What I Care About This Week | 2022 Apr 25

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by Franklin J. Parker, CFA

The Summary

The Details / Chart of the Week

Valuation is a word thrown around a lot, but what does it mean?

Very simply, valuation is the number of dollars an investor is willing to pay for $1 in company earnings. Of course, there are many different methods of measuring this. A method popularized by Nobel laureate Robert Shiller is the cyclically-adjusted price-to-earnings ratio, or CAPE ratio for short. While not as straightforward a measure (like the simple price-to-earnings ratio), it does a better job of showing the longer-term trends in valuation.

This week’s chart shows the historical valuation of the S&P 500. After reaching valuations that were more expensive than 98% of its history, the S&P 500 has begun to retreat a little (though it is still above its 95th percentile). Some of that is from recent price falls, but some is also from earnings growth. While I would expect this reduction in valuation to continue due to the Fed’s change in policy, we did see a similar retreat in 2018-2020, only to move to still newer highs.

In the end, it is important to note valuations (and the risks thereto), but they are also not a useful short-term trading tool. That is, valuations give us very little information about how markets will behave over the coming months or next few years, as our second plot demonstrates. One-year returns for markets are fairly random. However, longer-term returns tend to inversely correlate to valuations (high valuations tend to yield lower returns and vice versa).

As always, we are forced to assess and balance risks that you can afford to take. And, as we have talked about ad nauseum, flexibility is key in this environment.

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