Many investors view valuation metrics as crucial indicators. With P/E ratios nearing 30, there’s a growing sentiment that the bull market is nearing its end.
However, it’s worth noting that valuations have never really predicted stock price movements. This might sound controversial, but historical data supports the idea that high PE ratios don’t necessarily signal an impending decline.
This isn’t me speculating about 2026—my forecast will be unveiled later—but the point about valuations remains unchanged. Experts reference various timing indicators, including dividend yields and price-to-book ratios, not to mention my own price-to-sales metric developed over four decades ago.
Logically, low valuations imply “cheap” stocks, prompting the advice to “buy low.” Conversely, high valuations might suggest caution, predicting lower profits or, in a worst-case scenario, downturns, which is why so many are on edge right now.
This fear stems from a primal instinct. Our ancestors learned to avoid heights to escape danger—wise advice for personal safety, but not necessarily for investing.
Look at the S&P 500 and a significant but intricate measure known as R-squared, which assesses how well one event explains another. An R-squared of 0 indicates no connection, while 1.00 suggests a perfect relationship.
Since 1872, the R-squared between the S&P 500’s annual starting PE and subsequent one-year returns has hovered near 0.01, suggesting virtually no correlation. Over three- and five-year periods, these statistics stand at 0.03 and 0.02. So, essentially, only a tiny fraction of future returns can be traced back to PE. It’s mostly randomness—thinking otherwise seems, well, misguided.
Why? Because valuation metrics are well-known and already incorporated into stock prices. Also, stock prices tend to be forward-looking, while earnings reflect past performance. Even the anticipated profits many depend on are shaped by current expectations and factored into stock prices, sometimes incorrectly.
This disconnect can make a high P/E ratio appear unreasonably inflated during prime buying moments. Take early 2009 as an example: stock prices surged on hopes of economic recovery, even as declining revenues hadn’t yet impacted valuations. The S&P 500 had a P/E of 17 in late 2007, soaring to 60 by early 2009. Was that overpriced? Not necessarily—many viewed it as a once-in-a-lifetime buying chance.
Of course, rising P/E ratios can sometimes lead to disappointing returns. Back in the early 2000s, when the S&P 500’s P/E exceeded 30, returns fell to -2.3% annually over the next five years. During 2022, a similar scenario played out when the index started the year near 30 and ended with an -18.1% drop.
Yet, those high P/Es have also led to impressive returns. For instance, in 2003, the S&P 500 opened with a P/E of 32, and stocks climbed by 29%, averaging an annualized return of 12.8% over the next five years. And even starting 2021 with a P/E around 38, stocks still returned 29%, with a 10% annualized return over the subsequent three years.
Throughout 2009 to 2025, U.S. price-to-earnings ratios remained elevated. Despite facing two bear markets, the stock market achieved a staggering 944% increase by October.
Then there’s the well-known “Cyclically Adjusted PE (CAPE),” which seeks to smooth out cyclical fluctuations by averaging profits over ten years, adjusted for inflation. While it’s not meant for timing the market, many still use it that way.
There are some trends where CAPE does perform adequately, with an R-squared for ten-year future returns around 0.30. However, this still leaves 70% of the ten-year return unexplained. Over both shorter and longer time spans, its predictability diminishes to randomness. So, why gamble your retirement on an unreliable metric?
Valuation metrics do have their uses. They can help identify stocks within the value sector—and that’s partly why I developed the price-to-sales ratio. But when it comes to predicting broader market trends? That’s a different story.
Your faith in the predictive powers of valuations could very well set you up for market troubles. Perhaps it’s time to challenge those conventional beliefs.
