News > Capital Markets

That was not a crash

By Advisor Perspectives
Capital Markets

Following the market decline of recent weeks, the most reliable valuation measures we identify now project average annual nominal returns for the S&P 500 of about 0.5% in the next 10 years. On a broad range of historically reliable valuation measures (see Ockham’s Razor and the Market Cycle) the May peak in the S&P 500 reached valuations averaging about 114% above run-of-the-mill historical norms – more than double the valuation levels that have historically been associated with the 10% average expected market returns that investors have enjoyed over the long-term. At present, those measures have retreated to about 92% above historical norms.
Keep in mind that low interest rates don’t raise the estimated 10-year expected return on stocks from the current 0.5% level. Low interest rates only make the low expected return on stocks somewhat more “acceptable” because the alternatives are similarly dismal. The Federal Reserve’s policies of zero interest rates and quantitative easing have done nothing but to encourage yield-seeking speculation, bringing valuations to extreme levels, and leaving prospective future investment returns equally depressed.
Those who assert that high equity valuations are “justified” by low interest rates are actually (and probably unknowingly) saying that 0.5% expected returns on equities over the coming decade are a-okay with them. But it’s critically important to understand that while low interest may help to explainwhy current market valuations have been driven to obscene levels, low rates do not change the relationship – the correspondence – between elevated valuation levels and dismal subsequent long-term market returns.
The chart below shows the relationship between the most reliable valuation measure we identify (MarketCap/GVA) versus actual subsequent S&P 500 total returns over the following decade. The current level of valuations is associated with a likely range of 10-year returns between about -3% and +4%, with an average expectation of 0.5% annually.

The following chart shows the same data from a time-series perspective. Try the identical analysis with other popular valuation indicators and you’ll see why we rely on MarketCap/GVA and similar variants such as price/revenue, market cap/GDP and our margin-adjusted version of the Shiller P/E. We see all kinds of valuation metrics trotted out by analysts as if they’re meaningful. It’s only when investors examine the historical data (or live through the consequences of failing to do so) that they realize how little relationship many popular valuation metrics have with actual subsequent market returns. For our part, we insist on evidence. It makes us much less fun to hang around with at parties if the conversation turns toward the markets.

Market conditions will change. Look at every market cycle in history, and you’ll see that prospective market returns have always approached 9-10% or more in every market cycle – even when interest rates were similar to current levels (prior to the mid-1960’s). The best opportunity to boost investment exposure is at points in the market cycle where a ma

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