Extreme Valuation in the Time of Indexing

According to Morningstar, close to half a trillion dollars flowed into passive funds and ETFs in 2016. This at a time when equities are near their all-time highs statistically speaking. The chart below shows the P/E ratio for the S&P 500 as a percentile over time. What does that mean? It means that given the valuation of the market at any point, this chart explains what percentage of observations fell below that reading over the life of this measure. Take the most current observation for example. The trailing twelve month P/E based on reported earnings as of December 31, 2016 was about 23 times earnings (and this will change, as only about 59% of S&P companies have reported earnings thus far). That observation was at the 87th percentile. Therefore, 87% of all P/E observations from 1936 through 2016 fell below the current reading.

It strikes us as odd that investors are bailing on active management generally, and risk managed strategies, like managed futures and long/short equity specifically, when valuations are higher than they’ve been over 87% of the time over that last 80 years.

We’ve written frequently about the fact that valuation is itself a terrible timing tool. But it’s equally important to understand that risk is heightened at moments of high valuation because investors are more cognizant of the fact that everything must go right to support such valuations. Given the chaotic political environment unfolding in D.C., we certainly think investors should pause before dumping even more money into strategies with nobody at the helm to think about risk.

PE Blog Chart