The stock market's most popular valuation tool is only useful for the long term, equity strategist says

• P/E ratios are far more useful for indicating the direction of the market in the long term, an LPL Financial equity strategist wrote in a research note.
• Going back to 1990, the S&P 500's P/E ratio has been a much stronger predictor on a forward 10-year basis than for one year, Jeff Buchbinder found.
• While today's P/E ratios are high, "fundamentals are quite good right now, so these elevated valuations may persist throughout 2024 and potentially even longer," he said.

The price-earnings ratio is perhaps the most widely used and cited stock market valuation metric.

Right now, with stocks hitting a series of record highs, some market pundits are quick to point at historically high P/Es as a sign that equities are overvalued.

Jeff Buchbinder, chief equity strategist at LPL Research, thinks people using P/E as a near-term indicator have the wrong idea. He argues in a new research note that the metric is better used to gauge long-term market performance, and that it's proven ineffective over shorter time frames.

"P/E offers very little insight into whether stocks will do well or not in the coming year," Buchbinder wrote.

The chart below plots trailing 12-month P/E ratios against one year forward S&P 500 returns. He notes that if high P/Es actually signaled weak near-term performance, the entries on the chart would reflect a downward-sloping pattern. Instead, it "shows no relationship whatsoever" and "offers very little insight," according to Buchbinder.

But this isn't the case over a 10-year time horizon. Buchbinder points out that chart below shows the clear downward-sloping trend not present in the first chart.

"In other words, valuations are important for long-term buy-and-hold investors, but not so much for traders or your typical tactical asset allocator," he wrote.

This data shows that stocks are not necessarily doomed, despite high P/Es. And it aligns with what some experts have said recently, including Bank of America US equity-strategy chief Savita Subramanian. She wrote in late February that while stocks look "egregiously expensive," investors should still buy into the market, because certain conditions — like higher company quality and lower earnings volatility — have rendered traditional valuation metrics irrelevant.

"Stock valuations are clearly elevated, especially technology stocks benefiting from the artificial intelligence boom," Buchbinder wrote. "We're probably overdue for a pullback. But fundamentals are quite good right now, so these elevated valuations may persist throughout 2024 and potentially even longer."