The relationship between the economy and the stock market is a study in contradiction. It’s precisely when economic optimism is strongest, when caution is seen as misguided, and when bullish enthusiasm is most exuberant, that the stock market reaches its speculative apex and becomes most vulnerable to collapse. It’s precisely when economic pessimism is most dismal, when hope is set aside, and when bearish consensus is most dire, that market plumbs its deepest lows and carries the greatest potential for future returns.
If you think about the market as an equilibrium where every purchase has to be matched with a corresponding sale, this apparent contradiction vanishes. See, it’s precisely the untethered bullish enthusiasm of buyers, and the corresponding reluctance of sellers to part with their shares, that generates extreme overvaluation. Offensive valuation extremes could emerge no other way. Likewise, it’s precisely the wide-eyed fear of sellers, and the corresponding reluctance of buyers to absorb new shares, that generates extreme undervaluation.
Understanding this, it’s essential to resist the popular but misinformed impulse to believe that economic optimism itself is a useful or valid basis on which to invest in securities. What’s required instead is an insistence on recognizing that the long-term total returns that investors actually achieve from their investments are tightly linked to the valuations that they pay. As we’ve detailed in scores of prior commentaries, the most reliable market valuation measures we’ve identified have correlations of 90-94% with subsequent S&P 500 10-12 year total returns.
The chart below updates several of these measures as of last week. We continue to view recent market action as the likely final blowoff of one of the most extreme speculative episodes in U.S. history. The valuation measures we identify as most tightly correlated with actual subsequent S&P 500 total returns in market cycles across history range about 160% above (2.6 times) their historical norms, and more than 5 times the levels observed at points of secular undervaluation such as 1949 and 1982. This implies that a rather run-of-the-mill retreat to historical norms would now be associated with an expected market loss of about -60%, while a retreat even to a level still 25% above historical norms would be associated with a market loss exceeding -50%. That range of prospective market losses between -50% and -60% is in fact our expectation over the completion of the current market cycle, and neither would take reliable equity valuations below their long-term historical norms.
Of course, several popular and unreliable valuation measures are less extreme, but those measures also have generally weak correlations with subsequent market returns, invariably because they ignore the tendency of profit margins to fluctuate over the economic cycle. Investors should be particularly attentive to the fact that the median component of the S&P 500 is now far more overvalued than in 2000, 2007, or indeed in any prior point in history, and unlike 2000, small-capitalization indices are also breathtakingly overextended. As Benjamin Graham warned, “Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of good business conditions. The purchasers view the good current earnings as equivalent to ‘earning power’ and assume that prosperity is equivalent to safety.”