The straight P/E ratio is a poor forecasting tool when applied to the stock market.

Even the ten-year cyclically-adjusted P/E ratio isn’t much cop, although it’s probably the best of a poor bunch of crystal balls should we be silly enough to try to outwit the market. (Reminder: Such guesswork is decidedly optional, especially for passive investors!)

There is an exception to the bit-of-a-crap-shoot principle, though.

Developed markets on very low P/E ratios have nearly always been amazing buying opportunities. If the P/E of the stock market ever again falls below 8, I’d buy all you can. Then sell your grandmother and buy some more.

The reason for the juicy returns are pretty obvious – on a P/E ratio of less than 8, the market is pricing in cataclysm. So far the worst hasn’t happened to Western markets, so anyone who was brave enough to buy when shares were at such bargain basement levels has been well rewarded.

Remember some markets don’t make it. The Russian and Chinese stock markets in the early 20th Century went to zero! If they passed through a P/E of 10, 8, or 2 on the way down it didn’t make any difference – you still lost all your money. There is always a risk of something similarly awful happening in the future, and that risk is essentially what buys your returns.

Absent a communist revolution though, a very low P/E ratio buys you a huge margin of safety, and a lot of future earnings on the cheap.

The stock market valuation bull’s eye

More interesting – and maybe more surprising – is what happens with returns when you buy above the “a P/E of what? Is that a misprint?!” range. These higher P/E ratios are a matter of practical importance, because you’ll far more often see a market on a P/E in double-digits than on a P/E of <8.

In fact, if you only invest in the market when P/E ratios are at the bottom of the barrel, you could be waiting for decades to strike – and depending on your selling rules you could be out again within a year.

Most of the time you’ll need to pay higher P/E multiples for your ongoing equity fix and the superior returns that shares can deliver. But how much is too much?

The following graphic from City Research sheds some light with respect to the S&P 500 index of leading US shares:

Source: Business Insider

This graphic ranks P/E bands based on the average subsequent 12-month returns since 1940. Citi Research’s Tobias Levkovich crunched 73 years worth of S&P 500 returns data to produce it, dividing returns into bands by P/E rating ¹, and putting the higher performing bands closer to the bulls eye.

Remember: The Vanguard research I linked to at the top of this post showed P/Es have a poor record of forecasting market returns. I highlight this data to show that very cheap is good, and very expensive (a P/E above 20x) has been poisonous. It’s also useful to see that, as I speculate below, low to mid-teen P/E ratios have not historically been a reason to bail out of stocks. But don’t mistake this for a solid prediction machine. (There isn’t one).

Looking at the dartboard, as you’d expect from my comments, very low P/E ratios are associated with the highest average returns the following year.

With a P/E below 8, you’re paying less than $8 for every $1 of earnings (for an earnings yield of 12.5%). When you buy the market at such fire sale prices, there’s a strong chance that good things will happen!

It’s a bit different with individual companies. A company on a low P/E ratio might well be correctly priced because its business is in difficulties, or because its profits will never grow much. Sometimes that’s not the case – that’s why the value premium exists – but pretty often it is, which is why we’re not all millionaires from simply buying low P/E shares.

A P/E of 8x or less for the whole market is another kind of animal. Here you’re buying a slice of all the earnings of all the companies. Your investment will be driven by the largest companies, sure, but you’re still getting a lot of diversification, and lots of companies that will recover, as well as the deadbeats.

For that reason, I’d argue a low P/E market is a very different bet to a single company on a lowly P/E rating, and a much surer indication of value.

Stock market returns by P/E ratio

What’s also interesting about the dartboard is that outside of the bulls eye, the next band in the dartboard is not the 8-10x band, but rather the 14-16x band.

Of course this could just be a reflection of what the Vanguard study found – that you can’t learn much from P/E ratios.

But I can’t help wondering if it reveals a little bit more?

By implication, markets sporting P/Es in the 8-10x range proved, with hindsight, on average more expensive buys, whereas the 14-16x band was on a short-term basis a solid buy.

In fact, the 12-month returns for the 14-16x band were better than the entire range from P/E 8-14, as you can see in the data below:

P/E range	Average	Median
<8x	18.6%	18.8%
8-10x	8.9%	6.7%
10-12x	9.7%	9.6%
12-14x	11.2%	13.4%
14-16x	12.6%	14.6%
16-18x	5.4%	9.1%
18-20x	5.9%	6.5%
>20x	-.43%	4.43%

Source: Citi Research / Business Insider

Once the P/E ratio gets above the 8 threshold, median returns for the S&P 500 over the next 12 months creep higher and higher, but they don’t peak until the 14-16x range.

Above 16x they swiftly collapse again, on a median return basis. And if anyone ever calls the market a screaming buy on a P/E of over 20x, scream back at them. (And keep your money away!)

Reassuringly expensive

What gives? Is this random, or can we speculate about why the more expensive P/E ratios are delivering higher 12-month median returns?

Very possibly not. Even 70 years of returns only encompasses a few market cycles, and the stock market constantly reacts and changes, too. It might have been luck that the data fell this way, and even if it wasn’t that’s no guarantee it will hold in the future.

Remember too that these are averages and median figures. They will conceal big variations, including negative periods of returns where shares were in the dumpster for the following 12 months.

One thing it does tell us is to be wary of people who warn of imminent crashes just because the P/E ratio has gone up from a lower level.

Looking at the data, a higher P/E ratio has been associated with higher median returns all the way from 8-16x. The data doesn’t necessarily imply any inevitable smooth rise like that – but I do think it’s one in the eye for the doomsters who claim markets are expensive just because they’ve bounced off their lowest levels, especially with interest rates so low.

Finally, if I put my speculation hat on, I think it’s a good reminder that cheapness isn’t the whole story.

I’d hazard a guess that P/E ratios of 14-16x are associated mostly with expansionary phases for economies. At such times, people are getting more confident and bidding up shares – remember, the market discounts the future, not the past – but not yet to crazy bubble levels.

Because stock markets climb slowly but jump off a cliff on the way back down, I doubt the market spends much time in the giddy 14-16x band unless the news is at least fairly optimistic.

To return to the individual shares analogy, paying a P/E of 14-16x for the market is the equivalent of stock pickers who look for Growth At A Reasonable Price (or GARP for short).

GARP investors want to see further expansion and higher profits ahead. They don’t want to pay through the nose for it, because they believe very high rates of growth are not typically sustainable for long enough to make up for paying a very high multiple on purchase. But modestly high P/E ratings are a positive with the GARP methodology, since it indicates the expectation of higher earnings.

It comes down to the ‘E’ part of the ratio – the earnings. Higher earnings will bring a P/E ratio down – or hold it steady – just as surely as lower prices (the P) part will. So if you think earnings will rise, you might bid up for them in advance.

People are far more obsessed with fluctuating share prices than with the prospects for underlying earnings, so they often forget this.

P/E is not a prediction

Remember that as well as being extremely difficult, valuation isn’t the same as forecasting.

One weakness in this study, to my eyes, is that the subsequent returns are just tracked for a year. Most of us should be investing with a far longer time horizon if we’re in shares. A 12-month period of slightly lower returns doesn’t matter if it means we’re all set when things pick up after that.

As always, I think most people are best off ignoring all this and investing passively. But for those who do want to flex their inner Master of the Universe, I think valuation – as in not paying over the odds – is a better path, and a better use of this sort of data – than trying to forecast short-term returns.

Some may say I’m quibbling over semantics and it amounts to the same thing, but I think the mindset is different: I believe an active strategy based on trying to get a good deal when you buy is one that will serve you better than a strategy that tries to guess what the deal will be in a year.

1. I am 99% sure this data is based on forward P/E ratios, which is to say it’s looking at how the market is priced based on analysts forecasts (and some won’t like it for that reason). If anyone has access to the Citi Research directly and can confirm in the comments, please do![↩]

I hit the halfway mark of my mortgage-free marathon a couple of years ago, and I hit the wall at the same time. The journey seemed endless and morale was low.

I wrote a post as a form of self-help and discovered a cache of Monevator readers who cheered me up and along with their inspirational comments.

This intervention from Ermine, in particular, gave me heart:

The good news is it’s on the up from now – the last half of goals like that go quickly, as the initial investment starts to pay returns. As my mortgage dropped, I could pay increasing amounts of what was left, which rocketed in the second half.

The really good news is: he was right.

Thanks to a strong wind from the equity market, and merciless saving, we’ve ¹ hit the magic number two years early.

I now own as much as I owe and all that remains is to hand over the loot to the bank. No longer will they be able to invite themselves round for a ‘chat’ if I can’t keep the payments up.

A funny thing happened on the way to the bank

When I became effectively free of the mortgage, the weirdest feeling was that I didn’t feel anything at all.

A smile and a hug with Ms Accumulator, a couple of “I’ve done it” emails to close friends.

I tried to mark the occasion. After all the effort, I mounted my own winner’s podium to greet the applause of my super-ego and… *clunk*… nothing… silence.

Is that it?

Am I broken? Sterile? An emotional Sahara?

No. As grief can be delayed, so can gratification. It may have been re-routed by my emotional sat-nav but happiness has arrived, just not in the guise I expected.

Exhilaration sent its apologies along with two quieter stand-ins: soothing satisfaction and renewed determination.

Because the game is far from won. Paying off the mortgage was only the qualifying round. Financial independence is my Olympic Final.

I couldn’t think about competing for that until I’d bested my debt.

Now I know I can do it. I showed the discipline, stamina, and resolve to hold on during the impossible years. I can face down consumerism and resist the urge to buy a pint of fast-acting pleasure here and a box of cheery moments there.

Better still, I know it’s worth it. I haven’t missed out. Because everyone who’s been there before me and told me it’s one of the best things they’ve ever done – they were right.

The great escape

I feel like Houdini at the moment he gets an arm free. I may still be in the barrel heading over the Niagara but I can feel the chains slipping off and there’s still time.

Financial independence is a bigger challenge than paying off the mortgage. But I don’t think it will be as hard.

Because this time I have self-belief. Because I’m mentally in the right place. Because my value system is calibrated for freedom not fashion. Frugality is my ally, not an ailment. And with the mortgage done I can focus all my firepower on one goal: F.I. – Financial independence.

I can see it and I want it.

Take it steady,

The Accumulator

1. Ms Accumulator and I.[↩]

People are attracted to so-called alternative assets for various different reasons.

For some, tangible and desirable objects like stamps, paintings, and classic sports cars appeal in a way that shares in a company or government bonds can hardly match. ¹

Others are scared by the wild swings in share prices, and even in supposedly safe haven assets like gold.

Like those who argue that UK property will always be a good investment over the long-term, they believe a painting by a respected artist or a case of great French wine will hold its value whatever happens to shares.

But are they right?

Well, sort of.

Historical alternative asset class returns

Data on the historical returns from alternative assets is sketchy. Long-term returns tend to be whipped out by those with an alternative asset class to flog, although now and then you’ll find figures cited in academic research.

As I’ll get to below, investing in alternative asset classes also has more hidden costs than a Faustian pact with the tooth fairy.

However we have to start somewhere, and the Knight Frank Luxury Investment Index (KFLII) is as good a place as any.

The upmarket London estate agent tracks the sort of sexy alternative assets that appeal to the global elite that makes up its wealthy clientele. So no alternative investments in 1940s comics or Cabbage Patch Dolls here – it’s all fancy cars, classic watches, great wines, and the odd Ming vase.

Here are the one, five, and ten-year returns on the alternative assets it follows:

	1-year (%)	5-year (%)	10-year (%)
Antique furniture	-3	-15	-19
Watches	4	33	83
Chinese ceramics	3	43	83
Jewellery	2	51	146
Wine	3	3	182
Art	-6	12	183
Coins	9	83	225
Stamps	7	60	255
Classic cars	28	115	430
			—
KFLII	7	40	174
Gold	-23	68	273
Prime London property	7	27	135
FTSE 100	12	11	55

Source: Knight Frank

A few sources are acknowledged for this data:

• Prime London property is the return delivered by Knight Frank’s Prime Central London residential index.

• Other sources of data include the Historical Auto Car Group, Stanley Gibbons, and Art Market Research.

• The data for coins and jewellery is provisional from Q4 2012.

Getting back to the returns reported, on the face of it they look absolutely amazing.

Who wouldn’t want to have a luxury car parked in their garage and see its value go up over 400% for good measure?

Who indeed – but before you rush out to buy a Beamer, let’s quickly consider some of the snags.

Luxury assets are a luxury

Firstly, by its nature, this index follows the best stuff. It’s a luxury index, not an index of old tat offloaded at a car boot sale.

And sure, it’s easy to find examples of paintings by Picasso or pieces of furniture by 1930s modernists that have easily beaten inflation as well as every major asset class over many decades.

However these are the stars of the alternative asset world. Getting overly excited about them is a bit like judging the returns from shares solely from the returns made by those who bought into Coca-Cola in the 1950s. Many an antique banger or commemorative stamp has delivered much more mundane returns.

Survivorship bias also looms large. Andy Warhol’s early paintings now command millions, but what about his forgotten fellow pop artists? You can buy prints by some noted British rivals for a few thousand pounds. The divergence between the famous and the also-rans can easily be a hundredfold or more.

Then there’s the terrible liquidity of most alternative assets. You can sell a fund containing thousands of shares in 15 seconds. Try doing that with a Fabergé egg.

But suppose you do bag an Old Master. Where are you going to keep it? Who is going to look after it? How much will it cost to insure?

Knight Frank acknowledges this in the small print:

The index does not take into account any dealing, storage or management costs.

If cars, paintings, and bottles of Château Lafite could be bought cheaply on eBay and kept in the spare room, these returns would be more meaningful. But they can’t.

The historical returns from the FTSE 100 are also given without dealing and management costs, but for a cheap index tracker they’re a pittance by comparison.

Rich pickings

I’d also note the past decade has likely been a golden one for alternative assets.

We saw two big stock market crashes, which drove people to look for alternatives. Interest rates fell remorselessly, which reduced the effective cost of carrying income-less assets like gold. The financial crisis that made people lose their faith in all non-tangible assets was the icing on the cake.

There is however one tailwind that I think is likely to continue to blow positively for alternative assets (besides the hype factor), and that’s globalisation and the rise of the super-rich.

What good is it being a hedge fund manager, an oil sheik, or a Mexican telecoms baron if you can’t show off your wealth to the rest of the 0.1%?

Scarcity value will likely propel valuations for the very best paintings, properties, and collectibles for this reason, though I’m sure progress will be choppy.

Very rich people also tend to have the sort of private banking facilities and similar that reduces the incremental cost of storing just another classic watch.

Little alternative for the little guy

All these problems mean that most of us should probably avoid focusing on alternative assets, except when we want to own them for their own sake.

I was always told by rich people to buy antique furniture, for example, but its weak performance over the past ten years shows how fashions can change. However the price slide wouldn’t stop me buying a truly lovely Art Deco wardrobe that I liked. If it held its value, all the better.

Gold can be bought and stored fairly cheaply with the likes of Bullion Vault or via an ETF, but most of the other assets are hard to invest in with confidence.

Fine wine funds, for example, have had a lot of bad press after more than 50 reportedly went bust in just five years!

As a more active investor, if I was very optimistic about alternative asset classes I’d probably look into listed companies like Stanley Gibbons (stamps) and Noble Investments (coins). But these are small cap shares that come with their own lengthy risk list, and most people should steer well clear.

In fact, I can’t help feeling that interest in alternative assets is a sign that most people need to understand the traditional asset classes better. And be more wary of financial services geeks bearing antique gifts…

1. I know, who’d prefer to own an Aston Martin over an exciting stocks and shares ISA? Tsk! Some people.[↩]