The S&P 500 Costs 27.5 Times Earnings. History Says What a Starting Multiple That High Buys You Over 10 Years.

As of this writing, the Vanguard S&P 500 ETF (NYSEMKT: VOO) sits within about half a percent of its 52-week high of $714.16, trading around $710. Behind that price is a market that costs about 27.5 times its companies' earnings, far above the long-run average of about 16 for the S&P 500 (SNPINDEX: ^GSPC).

Setting aside stretches when collapsing profits inflated the ratio, as in 2008, the market has sustained a level this high in only two eras. One was the late 1990s. The other is the past two years.

Paying that much per dollar of earnings has had almost no bearing on what stocks do the next month, or even the next year. Over a full decade, it has mattered enormously.

So when investors have bought the index at a starting price like this one, what has the following decade actually paid?

Image source: Getty Images.

The one number known in advance

Nobody buying an index fund today can know next year's earnings growth, the path of interest rates, or which technology shifts arrive on schedule. The one input an investor knows with certainty is the price being paid per dollar of current earnings. Today that figure is about 27.5.

To me, that makes it the number worth dwelling on while the index sits this close to a high.

To be fair, Vanguard itself cautions that valuations tend to be poor predictors of short-term or even intermediate-term performance, and the firm says they shouldn't be a primary reason for changing an allocation. The market spent most of the past few years above its historical average multiple and kept climbing anyway.

But zoom out to a 10-year horizon, and the starting price has been one of the few signals that held up.

Three decades, three starting prices

The clearest case is the decade that began in January 2000. The S&P 500 entered it at about 29 times earnings, the richest starting point in its modern history. Over the following 10 years, the index's total return, dividends included, was slightly negative -- about minus 0.6% a year.

Investors waited a decade and finished with less than they started with.

Now run it from the other end. In August 1982, the index traded at about 8 times earnings. The following decade returned about 18.6% a year, one of the best 10-year stretches the U.S. market has produced.

VOO's own life sits between those extremes. When the fund launched in September 2010, the index cost about 15.6 times earnings -- near the long-run norm. Since then, the fund has returned about 15% a year, an extraordinary run that turned its buyers' starting valuation into more than a decade of double-digit compounding.

The pattern across all three periods points in one direction. Cheap starts have been followed by fat decades, average starts by strong ones, and the most expensive start on record by a lost one.

Profits could grow into the price

A high multiple can be worked off two ways: prices falling, or earnings growing into it. The 2000s delivered the first.

Today's buyers are counting on the second, and corporate profits have arguably been growing quickly enough to make that bet defensible.

Vanguard's own math, though, lands closer to the historical record than to the recent one. The firm's capital markets model forecasts U.S. equity returns of just 4.2% to 6.2% a year over the coming decade, and it attributes the muted outlook to valuations that have, in its words, "increased from already elevated levels."

That forecast doesn't call for a crash. It describes a market that may spend years earning its way back into its own price -- the slow version of what happened after 2000, softened by stronger profit growth.

And it implies about a third of the compounding rate the fund's shareholders have grown used to since 2010.

For the fund itself, nothing here changes what has always made it work. VOO charges a 0.03% expense ratio, so its investors collect essentially whatever the index delivers. What the index delivers from here is the whole bet.

I think the record is consistent enough to take seriously. Decades that began near today's multiple have been the market's leanest, and the 15% a year VOO's shareholders have enjoyed since 2010 was earned from a starting price about half of today's. History doesn't rule out another strong decade. It just shows that very few of them have started from 27.5 times earnings.

Daniel Sparks and his clients do not have positions in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.