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Do Stocks Tend to Slow Down after Multiple Expansion?

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While I don’t believe that stocks are in a bubble, multiple expansion does matter for future returns. Historically, markets have done slightly worse in years following multiple expansion. Since 1954, the return, net of dividends, on the S&P 500 has averaged 5.85% following years in which stocks got more expensive. In contrast, the average return following multiple contraction was more than 10%. Admittedly, the results seem to be disproportionately impacted by a few bad years, such as 2000 and 2002. If instead of using average returns, you focus on the median – which is less impacted by outliers – the difference is smaller: 9% in years following multiple expansion and 12.5% in years following multiple contraction.

stocks tend to slow down after multiple expansion

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Market Realist – Stocks tend to slow down after multiple expansion.

The S&P 500 Index (SPY) clearly performs much better following a year of multiple contraction—compared to a year of multiple expansion. This theme has been seen historically. Since 1996, the index has consistently performed better when the PE (price-to-earnings) ratio was contracting rather than expanding.

The average returns since 1996 for the S&P 500 (VOO), after the year that saw a multiple contraction, is 8.8%—compared to 6.5% when the multiple expanded in the previous year. This is in sync with the long-term trend, as you can see in the graph above.

The PE ratio expanded by 6% in 2014. The YTD (year-to-date) returns for the S&P 500 have been 2.2%. Stocks will likely be volatile (VXX) for the rest of the year. You should expect the returns for 2015 to be around that region. They could be negative.

However, there’s one more variable in the picture. Not only have multiples expanded, interest rates will be increasing soon. Treasury (TLT) (IEF) yields have reversed over the last few weeks. The higher interest rate changes the equation for stocks. We’ll discuss how stocks have performed when multiples are rising, along with interest rates, in the next part of this series.

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