In recent years, by starving investors of all sources of safe return, the Federal Reserve has successfully engineered an enormous upward shift in the short-run tolerance of investors to accept risk. Unfortunately, there is no reason to believe that human nature has changed as a result, nor is there reason to believe that the long-run, full-cycle tolerance of investors to accept risk has changed. In the short run – the advancing half of the full cycle – the tolerance for financial risk can be effectively rewarded, regardless of valuation, so long as prices are advancing and valuations are becoming progressively more extreme. These episodes typically end when historically identifiable syndromes of excessive speculation appear (the most extreme version we identify emerged as early as February 2013, and again in May, December, and today). Over the complete market cycle, the tolerance for risk can be rewarded only by the delivery of cash flows that are reasonable in comparison to price paid for the investment, coupled with the absence of significant downward adjustments in valuations over time.
During the past 14-year period, the S&P 500 has achieved a total return, including dividends, of just 3.3% annually. Even this outcome has been achieved only because market valuations have now been driven more than 100% above pre-bubble historical norms, based on reliable measures that are highly correlated with subsequent market returns. We emphasize reliability because there are countless measures that Wall Street analysts prefer to use, particularly those that make stocks seem reasonably valued. The problem is that most have very little relationship with actual subsequent market returns. When evaluating anyone’s valuation claim, you should always ask – how does this measure actually relate to subsequent market returns when it is evaluated over decades of market history?
Based on valuation metrics that have demonstrated a near-90% correlation with subsequent 10-year S&P 500 total returns, not only historically but also in recent decades, we estimate that U.S. equities are more than 100% above the level that would be associated with historically normal future returns. We presently estimate 10-year nominal total returns for the S&P 500 averaging just 2.2% annually over the coming decade, with zero or negative nominal total returns on every horizon of less than 7 years. Regardless of very short-term market direction, it is urgent for investors to understand where the equity markets are positioned in the context of the full cycle.
Last week, the S&P 500 closed at a record high. Based on valuation measures that have maintained a nearly 90% correlation with subsequent 10-year total returns (not only historically, but also in more recent decades), we estimate that the S&P 500 is more than 100% above the level at which it would be priced to achieve historically normal returns in the coming years. Another way to say this is that at current prices, we estimate negative total returns for the S&P 500 on horizons of 7-years and less, and nominal total returns for the S&P 500 averaging just 2.4% annually over the coming decade, with historically normal total returns thereafter. Needless to say, a steep intervening retreat in stocks could result in much stronger return prospects much, much sooner than 7-10 years from now.
Following a moderate decline from its recent highs, the market experienced a “reflex” advance last week. As I noted in the February 3 comment, “Even the shallow 3% retreat from the market’s all-time highs may be enough to prompt a reflexive ‘buy-the-dip’ response in the context of extreme bullish sentiment here, as the S&P 500 bounced off of a widely monitored and steeply ascending trendline last week that connects several short-term market lows over the past year. Regardless, the potential for short-term gains is overwhelmed by the risk of deep cyclical and secular losses. We presently estimate prospective 10-year S&P 500 nominal total returns averaging just 2.7% annually, with negative expected total returns on every horizon shorter than 7 years.”
On the basis of a broad range of valuation measures that are tightly (nearly 90%) correlated with actual subsequent S&P 500 total returns over the following decade, we estimate that stock prices are about double the level that would generate historically adequate long-term returns. The chart below presents estimated versus actual 10-year S&P 500 total returns using a variety of methods that I’ve detailed in prior weekly comments, and including a few additional ones for good measure. We presently estimate 10-year S&P 500 nominal total returns of only about 2.7% annually over the coming decade, with negative returns on all horizons shorter than about 7 years.
The latest data from the NYSE shows equity margin debt at a new all-time high. Relative to GDP, the current 2.6% level was eclipsed only once – at the March 2000 market peak. In the context of the most extreme bullish sentiment in decades, and reliable valuation metrics about double their historical norms prior to the late-1990’s bubble (price/revenue, market cap/GDP, Tobin’s Q, properly normalized price/forward operating earnings, price to cyclically-adjusted earnings), we view present market conditions as dangerously speculative.
Before it’s too late, I should note – as I also did at the 2007 market peak just before the market collapsed – that unadjusted forward operating P/E ratios and the Fed Model are both quite unreliable indications of value or prospective returns (see Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios).
The reason we generally don’t include late-90’s bubble data in the calculation of historical norms (though one should always be explicit about it), is that the S&P 500 has achieved total returns of hardly more than 3% annually for almost 14 years since the 2000 peak as the result of those valuations, and yet the historical extremes remain only partially uncorrected. We currently estimate nominal total returns for the S&P 500 averaging just 2.7% annually over the coming decade - no more than the present yield on 10-year Treasury bonds (though stocks are likely to experience far greater volatility and interim losses). These estimates incorporate a broad variety of fundamentals, including properly normalized forward operating earnings
Bernanke clearly meant it as a joke, but it is also an unfortunate statement on recent monetary policy. It's poetic that Stevie Wonder recorded Superstition in 1972, just before the stock market fell by half. A few weeks ago, William Dudley made the same point as Bernanke – even the Fed doesn’t quite understand how quantitative easing works. What FOMC officials are really saying is that aside from a very predictable effect on short-maturity interest rates, there is no mechanistic link between the monetary base and any other variables – financial or economic – that they are trying to control. There is a sense that creating more monetary base helps stocks advance, and that this contributes to economic confidence. What’s missing is a transmission mechanism that operates through identifiable banking and economic channels – other than promoting a speculative reach-for-yield and the psychological exuberance that accompanies a bull market.
In July 2011, just before the market lost nearly 20% (but also the last time it corrected materially), I observed “Like Wile E. Coyote holding an anvil just past the edge of a cliff, here we are, looking down below as if there is much question about what happens next.” In my view, the stock market is hovering in what has a good chance of being seen in hindsight as the complacent lull before a period of steep losses. Meanwhile, we would require a certain amount of deterioration in stock prices, credit spreads, and employment growth to amplify our economic concerns, but even here we can say that there is little evidence of economic acceleration. Broad economic activity continues to hover at levels that have historically delineated the border of expansions and recessions.