What Does This Historically Accurate Indicator Say About Future Stock Returns?

Witthaya / stock.adobe.com

The S&P 500, an index consisting of the 500 largest companies in the U.S. by market cap, has produced an average annual return of 10% between 1900 and 2022, assuming all dividends were reinvested. That's a respectable number, and given enough time, it could mean life-changing wealth for patient investors.

Looking ahead, investors can point to one important valuation metric to provide some insight as to where the market is headed in the future. Let's take a closer look.

Pay attention to this data point

The Shiller P/E (price-to-earnings) ratio, also known as the cyclically adjusted P/E or CAPE ratio, is a valuation methodology created by Yale economics professor Robert Shiller. It compares a company's stock price to its average earnings per share over the previous 10 years. The reason for this is to smooth out any significant fluctuations in profits.

Historically, the CAPE ratio has been pretty accurate in predicting future 10-year returns. For example, in the period between January 1995 and May 2020, it explained 90% of the variance in stock returns over the subsequent 10 years if you chose to start at any month, according to Advisor Perspectives. This is an impressive track record, especially when you consider the fact that the time period in question included the Sarbanes-Oxley Act, which altered accounting rules, as well as the Great Recession, when corporate earnings took a hit.

The highest level the CAPE has ever been at was over 44 in December 1999, just before the dot-com bubble burst. And over the following 10 years, between the start of 2000 and the end of 2009, the S&P 500 lost 24% of its value.

As of Jan. 13, the CAPE ratio was at 28. According to data provided by Advisor Perspectives, investors can expect annual returns to average between 6% to 7% for the next decade. That's far lower than the market's historical average return of 10% per year. Investors should also consider where interest rates are. The Federal Reserve has embarked on an aggressive tightening policy, which pressures stock valuations. If this continues, then it could mean more pain for investors.

Trader looking at charts on multiple monitors.

Image source: Getty Images.

What should investors do?

While it's hard to ignore how accurate the Shiller P/E has been in the past, investors shouldn't change their behavior based on one metric. It's still best to focus on what you can control, like your savings rate, mindset, and what stocks to buy for the long term.

Waiting for the CAPE ratio to decline before being a buyer of stocks is not the right move because you could miss out on returns in the meantime. And trying to time the market is a futile endeavor. Time in the market is what matters, especially for those who have a time horizon that spans decades.

The best investment strategy, at least the one stressed at The Motley Fool, is to invest in at least 25 businesses that possess competitive advantages, generate sustainable profits, have solid growth prospects, and that trade at attractive valuations. Plus, regularly adding to your portfolio on a recurring basis, something called dollar-cost averaging, is a worthwhile move that can improve long-term returns.

Use the CAPE ratio as a helpful gauge on the state of the markets and what the future might hold. But don't let it sway you from your plan.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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