The biggest concern I have for the future, when it comes to investing, is what the prevailing multiple might be for the stock market over the next several years — and that’s primarily going to be driven by future growth expectations and by interest rates. The S&P 500 is trading at pretty close to the average forward PE over the past 25 years, it’s at roughly 18X expected earnings today, and smaller cap stocks are trading at well-below-average multiples of forward expected earnings (S&P 600 Small Cap index is at about 12X forward earnings). That’s reasonably comforting, even if there’s some risk that companies are “over-earning” a little bit right now, with profit margins well above their historical averages.
If the inflation and higher interest rates and investor malaise we experienced from 1974 to 1984 are the better barometer of what the world looks like in the future, since that was the last time the US faced meaningful inflation and rising interest rates for a long period of time, then we have to at least keep in the back of our minds the lingering worry that the average PE ratio for that period of time was something around eight or nine. The average S&P 500 PE ratio didn’t bump into double digits at all from 1977 to 1982. This is what that looks like in a chart of average annual PE ratios for the S&P 500
If we lose our fascination with equities in a high-yield world, and growth is hard to come by, then the earnings multiple for the market could quite conceivably be cut in half as part of that adjustment. Which, assuming that average earnings for large companies stay roughly static, would mean the S&P 500 gets cut in half. There are lots of variables, of course — earnings could grow dramatically, and continue to outpace inflation, or we could see a recession and rising unemployment next year that causes interest rates to drop dramatically.
I don’t know what the market will do over the next year — another surging bull market is just as possible as a crash…
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