Valuation is a foundational concept in investing, as buying assets at lower prices can increase potential returns. However, this principle often fades from view when recent strong returns tempt investors to assume such performance will persist, disregarding valuation fundamentals. This tendency becomes especially prominent after prolonged gains, leading some to argue that valuations no longer matter.

But assessing value now is relevant, especially as markets have enjoyed a strong run, and valuations—particularly for U.S. shares—appear stretched. For instance, a recent Goldman Sachs analysis predicts that, based on current valuations and other factors, U.S. shares are expected to yield only around 3% annually over the next decade.

Enhanced Returns for Cash & Bonds Compared to Three Years Ago

Valuation, by nature, is typically expressed relative to an asset’s income potential. This makes valuing cash and bonds relatively straightforward compared to stocks, which can be more complex, or assets like gold and Bitcoin, where valuation becomes challenging due to the lack of inherent income. Fortunately, rising interest rates since 2022 have improved the appeal of cash and bonds as they now offer higher returns. Despite this, term deposit rates are still significantly lower than the 6–7% levels of 2010 and have recently softened in anticipation of RBA rate cuts.

For government bonds, yield provides a strong indication of starting value and, thus, medium-term return potential. A 10-year bond with a 5% yield, for example, promises a 5% return if held to maturity. This relationship isn’t flawless but serves as a useful guide. Historically, low bond yields signal lower medium-term returns and vice versa.

For stocks, a similar relationship holds: lower PE ratios (or higher dividend yields) tend to indicate better future returns. While less consistent than with bonds, this negative correlation shows that high PE ratios often lead to lower future returns and vice versa.

The Role of Investor Psychology and Valuation Limits

Starting point valuations significantly influence medium-term returns, as higher yields and lower PEs generally lead to stronger results. However, behavioral finance suggests investors often overfocus on recent performance, fueling a fear of missing out (FOMO) after strong gains. This tendency prompts buying after a period of growth, often resulting in overvalued purchases that may yield disappointing returns. Conversely, periods of weak performance may discourage buying, just when prices are most attractive.

Valuation, however, is not a flawless predictor. Its limitations include:

• Risk considerations: Assets can be “cheap” for legitimate reasons, as with a tobacco company facing lawsuits despite solid earnings.

• Timing limitations: Valuation is not precise for timing the market and may take years to play out.

• Measurement variety: Different earnings metrics in PE calculations (historic, forward, or smoothed) can produce varying results.

• Interest rate effects: Valuation levels fluctuate with inflation and interest rates, which influence yield structures and earning quality.

Current Market Valuations: Implications for Future Returns

The high valuations of U.S. shares suggest potential for lower returns over the next decade. This concern is amplified by the heavy concentration in tech stocks, which now occupy a substantial portion of the U.S. market, reminiscent of the tech boom peak in 2000. Fortunately, other markets are less inflated:

• Australian shares: Currently trade at a PE of 21, suggesting medium-term returns of around 8%.

• Eurozone shares: Have a PE of 15, offering a 4.6% risk premium over German bonds.

• Chinese shares: Exhibit a PE of 16 and provide a relatively high risk premium over bonds.

Key Takeaways for Investors

Elevated U.S. market valuations have several implications. First, they create vulnerability to potential downturns, especially with persistent recession risks, geopolitical tensions, and potential U.S. policy shifts under a possible Trump presidency. Second, they serve as a reminder that high returns cannot continue indefinitely. Lastly, the stretched valuations, particularly in U.S. tech stocks, suggest that a re-evaluation of U.S. shares within global portfolios may be prudent, though timing adjustments can be challenging.

The outlook seems reasonable for the next 6 to 12 months as central banks reduce rates and recession risks diminish, however, the current high valuations in U.S. markets suggest a future of more modest returns with heightened risks.

Rick Maggi CFP, Westmount Financial, Financial Advisor (Perth)

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Important note: While every care has been taken in the preparation of this document, Westmount Securities Pty Ltd (ABN 42 090 595 289, AFSL 225715) nor any other member of Westmount Securities Pty Ltd makes any representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.