The stock market's current valuation tells us 'zero' about what'll happen next

Morgan Stanley’s US equity strategy team published a note Monday titled “We Are Full of Bull.”

In it, strategist Adam Parker identifies a multitude of reasons to be bullish.

However, many of the more bearish folk continue to point to the S&P 500’s price-to-forward-earnings ratio (P/E), which at 17x is not reflective of a cheap market.

Parker actually believes the stock market could surge thanks to a P/E that could expand to 20x before this bull market peaks.

The bottom line for Parker, however, is that people shouldn’t be obsessing over P/Es in the near term.

“[K]nowing that we are one standard deviation above the long-term average on price-to-forward earnings, at 17 and change, has ZERO predictive value for the multiple in the next couple of years,” Parker asserts.

And based on the historical data, he’s right.

Here’s what the historical data says

“P/E has a poor track record for predicting shorter-term returns,” BMO Capital Markets’ Brian Belski wrote in March.

Belski tested the relationship between P/E and the 12-month returns using R2, a statistical measure which reveals how well a regression line — the line of best fit you see — explains the relationship. The higher the R2, the better better job a P/E ratio does in explaining returns.

“According to our work, the simple P/E ratio explains a significant portion of longer- term stock market returns (e.g., 10 years+, Exhibit 1),” Belski said. “On the other hand, P/E ratios have little explanatory power for holding periods up to 10 years.”

The fact of the matter is that P/Es aren’t that reliable over any given period. It’s just worse in the short-term, which at ten years is still a rather long time.

“Therefore, we believe investors are likely overstating the importance of elevated P/E levels as it relates to potential market performance in the coming months,” Belski said.

In February, Citi’s Tobias Levkovich ran a similar R2 test to show that the cyclically-adjusted price-earnings ratio does an absolutely horrible job of explaining 12-month returns.

“Although we do not discount the possibility of periods of market weakness — especially given the stage of the current cycle — nothing in our work suggests an imminent end to the current bull market,” Belski wrote.

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