The Effect of Overvaluation Over Time
Overvaluation and how it affects your returns is related to your timeframe.
The effect that overvaluation has on your investment returns is based on your timeframe. If the S&P is 30% overvalued, and your time frame is 3-5 years, you might want to avoid it, based on your alternative investment options. If your time is 30+ years, it will have a much different impact on your returns.
Assuming a stable valuation — meaning the price of the S&P 500 is the same multiple of the earnings now as in the future — your return will be made up of dividends and earnings growth. Historically, over the long term, the S&P 500's earnings have grown at about 6% [per year. If the current dividend yield is 2%, you can expect a total return of 8% per year.
Below is the expected return if the market is currently 30% overvalued and it reverts to its historical valuation over the time of your investment.
If the S&P P/E multiple drops 30% from the time you invested, let's say from 25 to 17.5, and the earnings grow 6% annually with a 2% dividend, your returns are going to vary significantly based on your timeframe. For a 30 year old who's putting money away for retirement, a 30% overvaluation is much less likely to have a significant effect on their return as a 60 year old trying to juice up their portfolio before they retire. A market can stay overvalued for a long time — just because you're buying at a 30% valuation premium — doesn't mean that premium will vanish in 5 years. It's just a risk factor that's more important for short-term investors.
Many choices in life are relative. Consider a 30-year-old aiming to nest their wealth until retirement, presented with only two investment paths. The first is an S&P 500 index inflated by 30%, the second a 30-year US Treasury Bond bearing a 3% yield. We believe the verdict should be clear-cut: back the S&P 500 all the way, and overlook US Treasuries. However, not all investors would share our viewpoint. Some might choose a portfolio with more balance.
For a market that's 50% overvalued and has a 2% dividend yield, the mean reversion returns would look like this:
At first glance, it might seem contradictory. You might naturally assume that if the market is overvalued by 50% and reverts to the mean, it would result in disappointing returns. This is undeniably true if your investment horizon is a short 5 years, but over a longer time horizon, the valuation contraction is amortized into a smaller drag on total returns per year. However, the situation changes if you are purchasing for entities like a family trust or other similar long-term commitments where your alternative investment options are confined to meager 2% treasuries.
