“A 40% increase in P/E ratio over a 40-year period increases returns by less than 1% annually. Similarly, a 40% plunge in the P/E ratio over that holding period reduces returns by just over 1% annually.”
- John P. Hussman (The 40 year forecast for the S&P 500 Index)
This makes sense to me.
The broad market’s P/E ratio is about 20 today. Is market overvalued? Undervalued?
Let’s suppose someone is in his/hers middle 20’s and buys into S&P 500 at today’s prices. This person wants to retire at the age of 65 and intends to sell the S&P 500 holding at that time.
If the terminal P/E at the sell-time is at 12, 40% below the P/E of today; the total impact on the overall return will be just about 1% annually.
Also, if the terminal P/E at the age of 65 is at 28, 40% above the P/E of today; the total impact on the overall return will be just about 1% annually.
The time is key here. The time dampens the effect of the swings in the market and smoothes out the averages. The big swings in the market valuations like the 40% rise or fall in P/E ratio has very negligible effect on the outcome of the long-time buy-and-hold portfolios.
Is market overvalued? If the time is on your side, paying 40% higher P/E will reduce your returns over the 40 years by only 1%.
Is market undervalued? You tell me.