 Good day, my dear investors! On Friday I discussed how that is a key risk component to the markets. I further said that there are other components in my view that create risk in the markets, that is valuation, extremely high book values, the notion that stocks can only go up and also real estate, and that if you just invest in index funds, put your money in index funds, you are well diversified and you will do well over time. So those are the key components of my risk perception over the markets and what can happen. So today we're going to talk about valuations and at the end of the risk series I'm going to tell you exactly what will be the best investing strategy and what to do from a very positive but based on knowledge and accumulation of facts what exactly you have to do in order to do well when investing over the next 20 years. But the key is to understanding the risk. So let's talk about valuations and how those create risk when investing. Going back to Buffett he says a lot of things but most of the things he says is sound eternal investment knowledge and one of the things that he stopped constantly repeating because he probably got tired of that is that your return on investment will be perfectly correlated with the earnings a company produces over time. So your return corporate earnings. The valuation can go up and down in cycles as it always does market cycles but as you're a long-term investor your long-term return will be related to earnings. So the focus is okay what are the earnings and what am I paying what's the price I'm paying for those earnings that is the valuation the price to earnings ratio. If we look at the SAP 500 the current price to earnings ratio is 25.13 and it has been higher only a few times in history somewhere in the 1800s still in the dot com bubble and of course in 2009 because SAP 500 earnings were very very low and that's why the price earnings ratio was high. Okay but price earnings ratio tell us okay they are really a static factor so you have to see how will that dynamically evolve over time. If the price earnings ratio is 25 the expected earnings will be 4 percent. However if we look at the growth of SAP 500 earnings we can see that it's always volatile. Now it is 20 percent looking back to last year but it was negative in 2016 it was almost negative in 2013 it was very very negative 90 percent decline in 2009 similarly 50 percent decline in 2002 when the last two recessions were. So the next recession we can expect again a drop of 50 60 70 percent. So don't expect that SAP 500 earnings grow 20 percent over the next 5 10 years because that never happened as you can see on this chart and will never happen probably this market is so crazy that anything can happen but okay going back to the SAP 500 earnings growth in 1980 the SAP 500 adjusted for inflation here earnings were 50 now they are 6.95 107 if I calculate the yearly growth over those 48 years I'm at 2 percent so SAP 500 earnings grew in the last 38 years 2 percent per year what does this mean this means that you can expect earnings to grow alongside the economy perhaps a little bit lower perhaps a little bit faster the economy is expected to grow at 2 3 percent over the very long term and with ups and downs you can expect SAP 500 earnings to grow at that rate so the return that you get from buying now is 4 percent and the growth earnings growth is 2 3 percent over the long term this means that your long long long term return from stocks will be 4 5 percent which is very low from a historical perspective and will dig deeper in a moment this is what I want to show you the SAP 500 level and price to earnings ratio if I start from the points the earnings of the SAP 500 in points is 107 this means that at the price earnings ratio of 50 the SAP 500 should be above 5000 at the price earnings ratio of 40 it should be above 3000 at the price earnings ratio of 20 above around 2000 2140 price earnings ratio of 10 at current earnings the SAP 500 should be at 1000 1070 points so that's the risk from an evaluation perspective and whatever if you look it from a dynamic market cycle that's a huge risk because if the required earnings from the SAP 500 are 10 percent somewhere in the next 10 years the SAP 500 will be at 1000 1100 1200 points as crazy at that might look now of course adjusted for inflation but inflation is something you have to think about so as crazy that might look now that's a huge risk for just investing in the markets additionally the bonds yields are increasing so let's say you are the manager of the Norwegian pension fund and you have your exposure to the united states and you look okay SAP 500 will give me 4 percent but now you see the 10 year treasury will give me 3 percent next year let's say 4 percent and then the fund manager of the Norwegian fund will say okay the risk is I need to adjust that for risks I want now 6 percent from the SAP 500 because I can get 4 percent for exposure to the US economy through bonds this means that the required earnings increase 50 percent which means that the valuation drops from the current 25 to 16 that means that if the required earnings yield from the SAP 500 goes to just 6 percent just 6 percent not 12 not 26 the SAP 500 drops to 1700 points and that's a risk for the general market if we look at a global perspective global developed perspective we can see here the third column the price to earnings ratio in brazil is 21 finland 22 indonesia 22 uk 22 belgium 23 almost philippines 23 united states 24 here data very a little bit around databases norway 24 switzerland 26 india 26 other emerging markets 28 emerging america 29 italy 30 say the highest price to earnings ratio in the world with the current election it will be even better nevertheless you can see how extremely high are the valuations and the second column here perhaps even more important is the cyclically adjusted price to earnings ratio which takes 10 year average earnings and that metric is even higher for the us and it is at 32 and let me show you this this is simply all you need to know about investing especially in the long term these are the returns on the x-axis you have the cyclically adjusted price to earnings ratio when it is 10 you can on average expect returns as you can see from all markets around the world of around 10 per year for the forthcoming 15 years on the y-axis you have the returns when the k-prasio is around 20 which means that earnings yield is around 5 percent you can see that the returns over the next 15 years are around 4 percent and the higher the cape is the lower are the returns and whenever the cape ratio is above 30 there is a bigger likelihood that the returns will be negative over the long term and you can see how whenever the cape was above 40 there are few exceptions when returns were barely positive over the 15 years in all equity markets however you can expect negative returns on a high cape ratio of at least returns not above 4 percent when the cape was above 20 the us market hasn't seen returns of above four five percent so that's it that's a huge risk for long term investors pension funds whatever however you are not a mutual fund which means that if you're smart you can carefully pick when to invest where to invest and how to invest i'm going to continue with my series on risk because that risk will lead us to the final video of the series when we will tell okay these are the risks which means that that is exactly what you have to watch in order to successfully invest over the very very long term looking forward to your comments thank you for watching i'll see you in the next video