You’ve probably heard it: “The stock market is expensive right now” or “Now is a good time to buy – the P/E ratio is low!” It sounds sensible. And yes, valuation is an important tool for long-term investors. But it’s not very useful if you’re trying to time the market in the short term.

It doesn't matter how low the valuation is – the market can still go down. And a high P/E ratio is no guarantee of an imminent decline. In the short term, the stock market is driven by other forces: expectations, interest rates, flows, macro, geopolitics – and not least by investor mood.

So the question is: How much does the valuation actually say about future returns? And on what time horizon Does it matter?

Market-level valuation: no help in 12 months

When we look at the valuation of, for example, OMXS30 – based on forward P/E ratios – and compare it to the future return one year later, the correlation is non-existent. The scatter plots look like a shower of confetti.

Why?

• The market is a complex system.
• In the short term, it is affected more by interest rates, inflation concerns, momentum flows and investor sentiment than by fundamentals.
• Multiples can both expand and contract without changing profits.

The result? You can buy “cheap” and lose money. You can buy “expensive” and have a fantastic year.

The scatter plot below shows the relationship between the stock market valuation (P/E ratio) and the annual return 12 months ahead. Each point represents a point in time: how expensive or cheap the market was – and how it fared since then. The spread is large. The market has sometimes given high returns despite high P/E ratios – and sometimes low returns despite low P/E ratios.

The R² value is 0.177, which means that only 17.7% of the variation in future returns can be explained by the P/E ratio. The rest – over 80% – is influenced by other factors: sentiment, interest rates, news feeds, psychology, etc.

What does it look like in 10 years' time?

When we look at the relationship between the stock market valuation (P/E ratio) at a given time and the average annual return over the following 10 years, we see a clear pattern:

The higher the valuation, the lower the future return. 57% of the variation in future returns over 10 years can be explained by how over- or undervalued the market was at the start. This is a much stronger relationship than what we see in the short term, where R² is often close to zero.

But what about individual stocks?

Here it gets a little more nuanced. Individual stocks can sometimes react more quickly to valuation differences, but that requires the market to revalue the company – and that doesn't always happen.

Two common scenarios:

1. Valuation doesn't matter in the short term here either. A company with a low P/E can remain undervalued for years unless sentiment changes. So-called value traps is more common than you think.
2. But in some cases, valuation can play a role more quickly. If the company delivers stronger results than the market expects, there is a greater chance of a revaluation – especially in smaller companies where new information is disseminated more slowly.

In short: At the company level, valuation can sometimes provide better guidance, but only if you combine it with other factors such as: growth expectations, competitive advantages, management, profitability and cash flows.

It is not enough to simply compare the P/E ratio to the average.

So how should one think?

• At market level: Use valuation as a long-term tool – not as a timing tool.
• At company level: Valuation can be a piece of the puzzle, but it requires you to understand the bigger picture. A low valuation is no guarantee of an uplift – it could just as well be a warning sign.

Conclusion

Valuation is like a weather forecasting tool – it works best when you zoom out. If you look too close, it's just noise.

So the next time someone says “the market is overvalued” or “this stock is cheap,” ask a counter question:

On what time horizon?

Everything is decided there.