Eyes Wide Shut

At the October 2002 market low, the S&P 500 stood -49.2% below its March 2000 peak (-48.0% including dividend income), with the Nasdaq 100 having lost more than -82.8% from its high, on the basis of both price and total return. The loss wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996.

The bull market that followed would bring the S&P 500 to a fresh high by October 2007. Unfortunately, in the face of historically extreme valuations, that victory also proved temporary, and the S&P 500 collapsed by -56.8% (-55.2% including dividends) by March 2009, with the Nasdaq 100 losing -51.9% (-51.5% including dividends) in that decline. The loss wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to June 1995.

The chart below shows the ratio of nonfinancial market capitalization to corporate gross value-added, including estimated foreign revenues, on an inverted log scale (left, blue), along with the actual S&P 500 nominal annual total return over the subsequent 12-year period (right, red). Notice the spikes in prospective returns that accompanied the 2002 and 2009 market lows. Spikes in expected future market returns mirror the periodic retreats in market valuation that have occurred regularly across history. During periods of very low interest rates, these spikes have sometimes ended in a valuation range consistent with 8-10% prospective 12-year market returns. In some instances, particularly following the soaring inflation of the late-1970’s, valuations collapsed to much deeper levels, with prospective future market returns spiking into a far higher range near 15-20%. Compare those periods with the depressed prospective returns implied by valuations at the 2000, 2007 and present market extremes.

It’s easy to forget that while the 2009 low took the most historically reliable market valuation measures only to moderately undervalued levels, particularly compared with secular undervaluation extremes like 1942 and 1982, that decline still left the S&P 500 -49.2% below the high it set nine years earlier during the tech bubble (-47.4% including dividends), while the Nasdaq 100 remained -77.8% below that high (-77.2% including dividends).

There’s no evidence that the mapping between historically reliable valuation measures and subsequent 10-12 year market returns has deteriorated at all in recent cycles. While the relationship isn’t perfect, it’s not surprising that at points of historically obscene valuations like 2000 (and today), market returns over the preceding 10-12 year period have been higher than investors would have expected 10-12 years earlier based on prevailing valuations at the start of those periods. That, of course, is precisely because the end-of-period valuations were temporarily and abnormally extreme. Nobody in their right mind would base their expectations for future market returns on the assumption that the market would stand at such extreme valuations at the end of the horizon.