Blissful Delusion

The present moment of blissful delusion is remarkable to witness. Take it in. A few words and updated charts will do.

The first chart below updates our variant of Robert Shiller’s cyclically-adjusted P/E (CAPE), where we’ve adjusted the measure to account for variation in the embedded profit margin; an adjustment that substantially improves the correlation of the resulting measure with actual subsequent market returns across history. Few investors recognize that one of the reasons why valuation multiples were so rich in 2000 is that profit margins were actually below historical norms at the time. It's also worth noting that the benefit of normalizing the embedded profit margin comes not just from muting margins that are above historical norms, but also from normalizing margins in periods where they are below historical norms.

The next chart shows the margin-adjusted CAPE on an inverted log scale (left, blue line), along with the actual subsequent S&P 500 nominal average annual total return over the subsequent 12-year period (right, red line).

The next chart updates our best estimate of the likely 12-year prospective total return on a conventional portfolio mix invested 60% in the S&P 500 Index, 30% in Treasury bonds, and 10% in Treasury bills. The current projection is the lowest in history, and I expect these weak passive investment returns, as they unfold, to trigger a rather broad crisis of pension underfunding in the years ahead. To estimate the S&P 500 component here, we’re using another measure I’ve introduced over time: the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues).