In part 1 of this series, I explained why the market’s red hot start to 2021, on track for 25% to 40% gains depending on the index, required earnings growth to be a blockbuster in 2021 and beyond.

So far Q1 earnings season has brought almost all good news, and expectations for 60% EPS growth through 2023 have fueled a bull market for the ages.

There’s even the chance that another $5.3 trillion in stimulus could drive double-digit earnings growth through 2024 or even 2025.

But there’s one more very important fact that investors have to know before they get too excited. This is the most important fact of all and it could determine whether you remember the post-pandemic boom with fondness or deep portfolio regrets.

Fact 3: Valuations Are Sky-High So Caution Is Warranted

Valuations are pretty much meaningless in the short-term.

Just 7% of 12-month returns since 1996 have been explained by valuations. In fact, just 43% of 5-year returns are a function of valuations.

This is why bubbles can last a long time, such as the epic tech euphoria rally of the late 90s that resulted in stocks becoming 67% historically overvalued.

But guess what? While valuations matter very little in the short-term, in the long-term they dominate stock returns. Bank of America’s quants have calculated, that, assuming relatively stable fundamentals for a company over time, 80% of long-term returns are explained by historical valuation mean reversion.

And over 10+ years 100% of stock returns are a function of starting yield + growth + valuation changes.

In other words, 91% of stock returns over the long-term are fundamentals driven, while just 7% of short-term returns are.

In the short-term luck is 11X more important than fundamentals. In the long-term fundamentals are 11X as important as luck.

As of April 16th, the market’s forward PE of 22.73 was 36% above the 25-year average of 16.67.

That means that on a forward PE basis, the most popular valuation metric on Wall Street, stocks were trading nearly 2 standard deviations above the norm.

Other valuation metrics show similar levels of overvaluation, include price/cash flow that’s almost 3 standard deviations above the historical modern-era norm.

Does this bode poorly for future stock returns? That depends on what kind of investor you are.

If you’ve gotten used to 15% annual returns from the S&P 500 and think that index investing can continue doubling your money every five years, then there is a 90% probability you’re going to be very disappointed over the next 10 years.

S&P 500 2023 Consensus Return Potential

(Source: F.A.S.T Graphs, FactSet Research)

60% EPS growth in the next three years, and it’s literally all priced in.

S&P 500 2026 Consensus Return Potential

(Source: F.A.S.T Graphs, FactSet Research)

87% EPS growth expected over the next five years, and analysts expect just 5% annual returns. That’s 1/3 what we’ve seen over the past decade and much lower than the 7% to 9% CAGR historical market return.

And of course, market returns never come smoothly but represent a winding and often frightening series of market rallies, interspersed with short and rapid declines.

(Source: Jill Mislinksi)

Fortunately, stock pickers don’t have to worry about how overvalued the S&P 500 ever becomes.

In fact, the more overvalued the broader market becomes, the more speculative manias are gripping the headlines, the easier it is for prudent long-term investors to earn market-smashing long-term returns.

Every Year Is A Stock Pickers Paradise But 2021 Especially

It’s always been, and will always be a market of stocks, not a stock market.

That means blue-chip bargains are ALWAYS available, even when the market has completely gone insane.

You might imagine that there were no good investments you could make in the most extreme bubble in US history. After all, when even Coca-Cola (KO) was trading at more than 40X earnings, how could any investor find a good deal?

Great blue-chip deals are always available, no matter how overvalued the stock market gets.

• Berkshire Hathaway (BRK.B) was 50% undervalued in March 2000
• Realty Income (O) was 50% undervalued in March 2000. Its price to cash flow was 7X and it yielded a very safe 11%.
• Enterprise Products Partners (EPD) was 50% undervalued. Its price to cash flow was 6X and it yielded a very safe 12%” – The Most Important Investing Concept 

At the very same time as some tech stocks were trading at 500X earnings (those that even had earnings) quality blue-chips could be purchased at a 50% discount.

Prudent long-term investors who avoided paying crazy valuations for stocks didn’t just avoid the stock market’s “lost decade” they made a fortune.

• BRK investors who bought during the tech bubble low made 25.1% annually over the next 15 years.
• Realty Income investors made 17.7% annually
• Enterprise Products Partners investors made 23.8% annually
• Smart long-term investors who recognized the difference between value and price during the tech bubble made 1,100% to 2,800% returns over the next 15 years.”  – The Most Important Investing Concept

How can you earn up to 2800% returns from a slow-growing dividend blue-chip over 15 years? You buy it at an anti-bubble price.

There was absolutely nothing wrong with these blue-chips in early 2020.

They were simply left for dead because of the “screw everything else, long live tech” mentality of the Dotcom mania.

Today the market is highly overvalued and reasonable people can debate about whether or not this is a bubble.

There is no question future returns will be lower, the question is how low will they be.

But rather than attempt the impossible, and try to time the broader market’s irrational short-term swings, why not just ignore high valuations entirely?

TROW 2026 Consensus Return Potential

(Source: F.A.S.T Graphs, FactSet Research)

T. Rowe Price (TROW) is one of the best dividend aristocrats you can buy today. And it offers almost 3X the market’s 5-year consensus return potential.

Amazon 2026 Consensus Return Potential

(Source: F.A.S.T Graphs, FactSet Research)

Amazon (AMZN) is also attractively valued, at a modest 22% margin of safety.

Analysts expect AMZN to potentially deliver 4X the S&P 500’s returns over the next five years.

Toronto Dominion Bank (TD) is the 2nd safest publically traded bank in the world according to Global Finance Magazine.

(Source: F.A.S.T Graphs, FactSet Research)

And it’s offering 2X the market’s long-term consensus return potential.

Alibaba 2026 Consensus Return Potential

(Source: F.A.S.T Graphs, FactSet Research)

Alibaba (BABA) is the single best deal in hyper-growth on Wall Street. It offers 5X the market’s consensus return potential for the next five years.

Looking for a 50% bargain? That’s British American Tobacco (BTI).

(Source: F.A.S.T Graphs, FactSet Research)

How does a safe 8% yield and almost 20% annual returns, or 4X that of the S&P 500 sound?

JPMorgan called 2021 a “stock picker’s paradise”.

I’ve been “stock picking” for 5 years at Seeking Alpha.

(Source: TipRanks)

Over 1,000 recommendations on over 500 companies over 5 years.

Including dividends, my average 12-month total return is +36%, excluding dividends, 32.1%.

Do I care about 12-month returns? Not really, just 7% of those are a function of fundamentals.

Do I use technical analysis? Absolutely note.

My entire approach can be summarized by Joel Greenblatt’s (40% CAGR total returns over 21 years) wonderful quote

“We’re buying above-average quality companies at below-average prices.”

That’s what I’ve been doing for five years. It’s made my readers a fortune, as well as myself.

And there is a 91% probability that my disciplined application of financial science will keep working over the coming decades.

Financial science is all about the making, in the words of Charlie Munger, “consistently not stupid” decisions.

It’s not magic, it’s just math. The math of getting and staying rich on Wall Street.

SPY shares were trading at $415.18 per share on Friday morning, up $2.91 (+0.71%). Year-to-date, SPY has gained 11.41%, versus a % rise in the benchmark S&P 500 index during the same period.

About the Author: Adam Galas

Adam has spent years as a writer for The Motley Fool, Simply Safe Dividends, Seeking Alpha, and Dividend Sensei. His goal is to help people learn how to harness the power of dividend growth investing. Learn more about Adam’s background, along with links to his most recent articles. More...

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