September 28, 2021

Chart of the Week: Current valuations and future returns – a cautionary tale

by Fathom Consulting.

The US Federal Reserve’s loose monetary policy and the relative unattractiveness of fixed income assets has encouraged investors into US equities, increasing equity prices. As a consequence, the cyclically adjusted price-to-earnings ratio (CAPE) for the S&P 500 is now within the top 95% of all historical values. The last time it was this high was during the dot-com bubble. Historically, we find that CAPE is negatively related to future returns, and when CAPE has been around the values seen today, the next ten years tend to see either very low or negative growth in average returns. It is difficult to predict when returns will weaken, but we can at least keep an eye on likely triggers, such as monetary policy tightening. According to projections released last Wednesday, a growing number of Federal Reserve officials now expect a rate increase next year. Another potential trigger could be more attractive fixed income investments as bond yields rise.

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