If someone ever asks me what I think the market is going to do next, I usually reply by saying I have no idea. I believe most investors would be wise to adopt this philosophy.
This still doesn't prevent people from trying to forecast where things will go next. As investors, we want to appear like we know what the S&P 500's performance will be in the future. Then we can position our portfolios accordingly.
But is there a data point out there that can signal with any level of accuracy what future returns will be? Read on to find out.
Image source: Getty Images.
Not a bad indicator
Every once in a while, I think the Shiller price-to-earnings (P/E) ratio, otherwise known as the cyclically adjusted P/E (CAPE) ratio, can provide a high-level view as to what prospective returns might be over the next decade. This metric is the P/E ratio of the S&P 500 using the average net income of the previous 10 years, adjusted for inflation.
If that sounds like a mouthful, don't worry. The objective of this data point is to smooth out any fluctuations in earnings. The highest it has ever been previously was in 1929 and 2000, and these times directly preceded bear markets. As you can see below, we are currently at the second highest level in history.
S&P 500 Shiller CAPE Ratio data by YCharts.
According to Advisor Perspectives, which provides news and commentary for financial advisors, the CAPE ratio explained an incredible 90% of the variation in returns from 1995 to 2020. In other words, for an asset class that's completely random, this is as accurate an indicator as we're going to get.
The S&P 500 has historically returned an average of 10% per year. But based on today's Shiller P/E ratio of 38, the market could be in for disappointing returns in 2022 and beyond.
However, I don't think investors should panic just yet. The Great Recession of 2008 and 2009 and the coronavirus pandemic led to unprecedented amounts of government stimulus to support economic growth. Even with an elevated CAPE ratio over the past 10 years, the stock market just kept climbing higher. Credit the Federal Reserve for perhaps distorting the correlation between the Shiller P/E ratio and future returns.
What should investors do?
I firmly believe that you should only invest money in the stock market that you don't need for the next five years. This is because in the near term, the market is extremely unpredictable, but over longer time horizons, the probability of a positive return increases dramatically.
With that in mind, if you're looking to put capital to work right now when interest rates are near zero, you really don't have any other option than to invest in the stock market. Although the Shiller P/E ratio might signal a poor decade of returns ahead, where else would you park your money?
I believe that owning a well-diversified portfolio (at least 25 stocks) of competitively advantaged businesses that have proven track records and solid growth prospects is the best strategy you can pursue. Names like Home Depot (HD 0.02%) and Starbucks (SBUX 1.09%) immediately come to mind.
The home-improvement giant has grown profits 16% annually over the past 10 years, is able to outshine competitors thanks to its massive scale, and still has huge expansion opportunities thanks to a robust U.S. housing market.
The giant coffeehouse chain possesses a powerful brand, supported by a top-notch loyalty program and premium status that resonates strongly with consumers. Starbucks' management estimates that by 2030, there'll be a whopping 55,000 locations worldwide, 63% higher than today's count.
Focus on what really matters
No matter what the Shiller P/E ratio says, I think Home Depot and Starbucks will continue to do well and be solid additions to anyone's portfolio. This is what investors must focus on. Concentrate intensely on the quality of the companies you own, and you'll surely do well over time.
Trying to time the market based on whether you think it's cheap or expensive is not a game you want to play. Adding savings at regular intervals -- known as dollar-cost averaging -- reduces any biases you may have and allows you to improve your cost basis on stocks you buy.
We're living in interesting times. There's still lots of uncertainty in the market today with no shortage of so-called experts telling us what we should do with our money. While the Shiller P/E ratio is a tool you can add to your investing arsenal, ignore the noise and keep your eyes on the long term.
