Stock Valuations Can Make a Difference In Your Trading Results

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John Forman - The Essentials of Trading author

I came across a post on the Generation X Finance website yesterday which discusses the value of using Price/Earnings (PE) ratios to estimate the likely return of the stock market looking forward. In this particular case, the author uses what is called the PE10, which is Price divided by the 10-year average earnings. The normal PE that we talk about would be PE1 - price divided by the last year’s earnings. And of course there is the forward PE which compares current price to expected earnings for the next year.

The article attempts to make the point that young investors should pull for a major correction in the markets because the current PE10 is at about 25, a high reading which implies poor future returns. Research has definitely indicated that low valuation investments outperform high valuation ones, but this particular article falls way short of hitting the target.

Firstly, the estimates are based on a linear regression model of market returns and academia has long sinces started moving away from those types of forecasts methods as market returns are most certainly not linear and do not conform to a normal distribution.

More importantly, though, the results of this author’s research tends to contradict his point. His figures show that the longer one stays in the market, the more irrelevant the initial valuation level. The variation in expected returns is by far the largest in the first 10 years, then rapidly moves toward zero. Presumably, a young investor has a multi-decade investing horizon, so initial valuation doesn’t mean anything. It’s the investor on the back side of their careers who need to concern themself with valuations - according to this particular study.

I personally am primarily a technical trader, but when trading stocks I do try to find relatively low valuation situations (or high for shorts) as they oftentimes can create that extra momentum in the stock price to really get things moving. It’s not a question of hard and fast rules, though. Valuation is a relative thing.

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