Chart of the Month | Understanding How Valuations Impact Portfolio Returns
The S&P 500 has rallied +50% since the start of 2023 and more than +150% from the COVID pandemic low in March 2020. The rally has produced a long list of all-time highs and boosted investment portfolios, but it has made broad market indices more expensive.
For your convenience, we’ve also provided a PDF copy of the Chart of the Month | Understanding How Valuations Impact Portfolio Returns
The S&P 500 currently trades at over 21 times its next 12-month earnings estimate, a level not seen outside of periods like the late-1990s tech boom and the recent post-COVID recovery, when interest rates were near zero. Why do high valuations matter? History shows that while valuations have a limited impact on short-term returns, they play a critical role in determining long-term performance.
Figure 1 shows the relationship between the S&P 500’s starting valuation and future returns. The horizontal axis represents holding periods in years, and the vertical axis shows the R-squared (R2) between the S&P 500’s starting valuation and its forward return. R2 is a statistical measure that shows the predictiveness between two variables. For example, an R2 of 0.40 indicates that 40% of the changes in one variable can be attributed to changes in the other variable, while the remaining 60% is due to other factors or random variation. The left side of the chart tracks short holding periods of only a few years, revealing a low R2 between valuations and forward returns.
The takeaway is that the S&P 500’s starting valuation doesn’t explain a significant portion of its short-term return. However, the R2 increases as you move across the chart, showing that valuation explains a larger portion of longer-term returns. For a 10-year holding period, the S&P 500’s starting valuation explains ~80% of the variability in returns, highlighting valuation’s importance for long-term investors.
Figure 2 expands on the importance of valuations by plotting the S&P 500’s starting valuation against its next 10-year annualized return. The starting valuation represents the S&P 500’s normalized price-to-earnings (P/E) multiple, which is calculated as the current price divided by the average inflation-adjusted earnings over the past ten years. The line slopes from the top left to the bottom right, indicating that as the starting valuation increases, forward returns decrease. The current normalized P/E ratio of 37 times is marked on the chart, suggesting the S&P 500 could produce somewhat lower returns over the next ten years. This highlights the importance of staying diversified with exposure to other areas of the global markets with more reasonable valuations.
While current valuations carry significant weight, it’s important to put context around historical analysis like this. While past performance offers valuable insights, it doesn’t guarantee future outcomes, and timing the market is difficult. Figure 1 shows that valuations aren’t reliable indicators of short-term market returns, and markets can remain expensive way longer than expected. However, given the rarity of today’s starting valuation, it’s important to
acknowledge the potential impact on forward returns when setting expectations for the years ahead.
Disclosure
The information and opinions provided herein are provided as general market commentary only – not financial advice – and are subject to change at any time without notice. This commentary may contain forward-looking statements that are subject to various risks and uncertainties. None of the events or outcomes mentioned here may come to pass, and actual results may differ materially from those expressed or implied in these statements. No mention of a particular security, index, or other instrument in this report constitutes a recommendation to buy, sell, or hold that or any other security, nor does it constitute an opinion on the suitability of any security or index. The report is strictly an informational publication and has been prepared without regard to the particular investments and circumstances of the recipient.
Past performance does not guarantee or indicate future results. Any index performance mentioned is for illustrative purposes only and does not reflect any management fees, transaction costs, or expenses. Indexes are unmanaged, and one cannot invest directly in an index. Index performance does not represent the actual performance that would be achieved by investing in a fund.
See Full Disclosures Page
Concerns or questions about how your investment portfolio will hold up in the current market environment? Contact Financial Synergies today.
We are a boutique, financial advisory and total wealth management firm with over 35 years helping clients navigate turbulent markets. To learn more about our approach to investment management please reach out to us. One of our seasoned advisors would be happy to help you build a custom financial plan to help ensure you accomplish your financial goals and objectives. Schedule a conversation with us today.
More relevant articles by Financial Synergies:
Blog Disclosures
This content, which may contain security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own financial advisors as to legal, business, tax, and other related matters concerning any investment.
The commentary in this “post” (including any related blogs, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Financial Synergies Wealth Advisors, Inc. employees providing such comments, and should not be regarded as the views of Financial Synergies Wealth Advisors, Inc. or its respective affiliates or as a description of advisory services provided by Financial Synergies Wealth Advisors, Inc. or performance returns of any Financial Synergies Wealth Advisors, Inc. client.
Any opinions expressed herein do not constitute or imply endorsement, sponsorship, or recommendation by Financial Synergies Wealth Advisors, Inc. or its employees. The views reflected in the commentary are subject to change at any time without notice.
Nothing on this website or Blog constitutes investment or financial planning advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. It also should not be construed as an offer soliciting the purchase or sale of any security mentioned. Nor should it be construed as an offer to provide investment advisory services by Financial Synergies Wealth Advisors, Inc.
Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Financial Synergies Wealth Advisors, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
Any charts provided here or on any related Financial Synergies Wealth Advisors, Inc. personnel content outlets are for informational purposes only, and should also not be relied upon when making any investment decision. Any indices referenced for comparison are unmanaged and cannot be invested into directly. As always please remember investing involves risk and possible loss of principal capital; please seek advice from a licensed professional. Any projections, estimates, forecasts, targets, prospects and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Information in charts have been obtained from third-party sources and data, and may include those from portfolio securities of funds managed by Financial Synergies Wealth Advisors, Inc. While taken from sources believed to be reliable, Financial Synergies Wealth Advisors, Inc. has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation. All content speaks only as of the date indicated.
Financial Synergies Wealth Advisors, Inc. is a registered investment adviser. Advisory services are only offered to clients or prospective clients where Financial Synergies Wealth Advisors, Inc. and its representatives are properly licensed or exempt from licensure. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
See Full Disclosures Page Here
Chart of the Month | Understanding How Valuations Impact Portfolio Returns
Chart of the Month | Understanding How Valuations Impact Portfolio Returns
The S&P 500 has rallied +50% since the start of 2023 and more than +150% from the COVID pandemic low in March 2020. The rally has produced a long list of all-time highs and boosted investment portfolios, but it has made broad market indices more expensive.
For your convenience, we’ve also provided a PDF copy of the Chart of the Month | Understanding How Valuations Impact Portfolio Returns
The S&P 500 currently trades at over 21 times its next 12-month earnings estimate, a level not seen outside of periods like the late-1990s tech boom and the recent post-COVID recovery, when interest rates were near zero. Why do high valuations matter? History shows that while valuations have a limited impact on short-term returns, they play a critical role in determining long-term performance.
Figure 1 shows the relationship between the S&P 500’s starting valuation and future returns. The horizontal axis represents holding periods in years, and the vertical axis shows the R-squared (R2) between the S&P 500’s starting valuation and its forward return. R2 is a statistical measure that shows the predictiveness between two variables. For example, an R2 of 0.40 indicates that 40% of the changes in one variable can be attributed to changes in the other variable, while the remaining 60% is due to other factors or random variation. The left side of the chart tracks short holding periods of only a few years, revealing a low R2 between valuations and forward returns.
The takeaway is that the S&P 500’s starting valuation doesn’t explain a significant portion of its short-term return. However, the R2 increases as you move across the chart, showing that valuation explains a larger portion of longer-term returns. For a 10-year holding period, the S&P 500’s starting valuation explains ~80% of the variability in returns, highlighting valuation’s importance for long-term investors.
Figure 2 expands on the importance of valuations by plotting the S&P 500’s starting valuation against its next 10-year annualized return. The starting valuation represents the S&P 500’s normalized price-to-earnings (P/E) multiple, which is calculated as the current price divided by the average inflation-adjusted earnings over the past ten years. The line slopes from the top left to the bottom right, indicating that as the starting valuation increases, forward returns decrease. The current normalized P/E ratio of 37 times is marked on the chart, suggesting the S&P 500 could produce somewhat lower returns over the next ten years. This highlights the importance of staying diversified with exposure to other areas of the global markets with more reasonable valuations.
While current valuations carry significant weight, it’s important to put context around historical analysis like this. While past performance offers valuable insights, it doesn’t guarantee future outcomes, and timing the market is difficult. Figure 1 shows that valuations aren’t reliable indicators of short-term market returns, and markets can remain expensive way longer than expected. However, given the rarity of today’s starting valuation, it’s important to
acknowledge the potential impact on forward returns when setting expectations for the years ahead.
Disclosure
The information and opinions provided herein are provided as general market commentary only – not financial advice – and are subject to change at any time without notice. This commentary may contain forward-looking statements that are subject to various risks and uncertainties. None of the events or outcomes mentioned here may come to pass, and actual results may differ materially from those expressed or implied in these statements. No mention of a particular security, index, or other instrument in this report constitutes a recommendation to buy, sell, or hold that or any other security, nor does it constitute an opinion on the suitability of any security or index. The report is strictly an informational publication and has been prepared without regard to the particular investments and circumstances of the recipient.
Past performance does not guarantee or indicate future results. Any index performance mentioned is for illustrative purposes only and does not reflect any management fees, transaction costs, or expenses. Indexes are unmanaged, and one cannot invest directly in an index. Index performance does not represent the actual performance that would be achieved by investing in a fund.
See Full Disclosures Page
Concerns or questions about how your investment portfolio will hold up in the current market environment? Contact Financial Synergies today.
We are a boutique, financial advisory and total wealth management firm with over 35 years helping clients navigate turbulent markets. To learn more about our approach to investment management please reach out to us. One of our seasoned advisors would be happy to help you build a custom financial plan to help ensure you accomplish your financial goals and objectives. Schedule a conversation with us today.
More relevant articles by Financial Synergies:
Blog Disclosures
This content, which may contain security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own financial advisors as to legal, business, tax, and other related matters concerning any investment.
The commentary in this “post” (including any related blogs, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Financial Synergies Wealth Advisors, Inc. employees providing such comments, and should not be regarded as the views of Financial Synergies Wealth Advisors, Inc. or its respective affiliates or as a description of advisory services provided by Financial Synergies Wealth Advisors, Inc. or performance returns of any Financial Synergies Wealth Advisors, Inc. client.
Any opinions expressed herein do not constitute or imply endorsement, sponsorship, or recommendation by Financial Synergies Wealth Advisors, Inc. or its employees. The views reflected in the commentary are subject to change at any time without notice.
Nothing on this website or Blog constitutes investment or financial planning advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. It also should not be construed as an offer soliciting the purchase or sale of any security mentioned. Nor should it be construed as an offer to provide investment advisory services by Financial Synergies Wealth Advisors, Inc.
Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Financial Synergies Wealth Advisors, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
Any charts provided here or on any related Financial Synergies Wealth Advisors, Inc. personnel content outlets are for informational purposes only, and should also not be relied upon when making any investment decision. Any indices referenced for comparison are unmanaged and cannot be invested into directly. As always please remember investing involves risk and possible loss of principal capital; please seek advice from a licensed professional. Any projections, estimates, forecasts, targets, prospects and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Information in charts have been obtained from third-party sources and data, and may include those from portfolio securities of funds managed by Financial Synergies Wealth Advisors, Inc. While taken from sources believed to be reliable, Financial Synergies Wealth Advisors, Inc. has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation. All content speaks only as of the date indicated.
Financial Synergies Wealth Advisors, Inc. is a registered investment adviser. Advisory services are only offered to clients or prospective clients where Financial Synergies Wealth Advisors, Inc. and its representatives are properly licensed or exempt from licensure. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
See Full Disclosures Page Here
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