As Markets Burn

Market Adjustments Alter Our Expected Return Forecasts

Over the last several years, we were often asked what catalyst could end the longest bull market in US history. Our response has always been that a catalyst, by definition, is a surprise to most of the market, so predicting what it might be is merely an interesting and occasionally useful parlor game—needless to say no one saw this one coming.

Over the last several weeks, the humanitarian crisis of the novel coronavirus has proven to be the match that lit the kindling of overpriced stocks, soaked by the kerosene of a slowing US economy. The OECD Composite Leading Indicators data series that forecasts the turning points of growth in the economy clearly shows that the US economy has been slowing for 18 months, starting in the third quarter of 2018. Equities’ poor performance in the fourth quarter of 2018 turned out in hindsight to be brush fire. We are now dealing with a full-blown conflagration.

The S&P 500 Index hit an intraday all-time high just under 3,400 on February 19. From that point, the US equity market fell by 35% in just over four weeks—the fastest decline from an all-time high ever—before rebounding in the later days of March and closing out the quarter at just under 2,600. Ten-year US Treasury yields are now well below 1.00% and even 30-year yields briefly dipped below 1.00% on March 9.

As we are all aware, the US stock market has experienced the longest bull market in its history. The result has been historically expensive equity valuation multiples, such as the cyclically adjusted price-to-earnings (CAPE) ratio,1 which had topped 30 prior to the abrupt market crash. The CAPE reached this level only twice before in history, in 1929, and during the 1999–2000 tech bubble. These high valuations are correlated with low subsequent returns as valuations revert to lower historical averages as stock prices fall, driven by the reduced risk appetites of investors.

Although the coronavirus caught everyone by surprise as the catalyst of the market’s downturn, we have had low expectations for US equity performance for quite some time. Over the last five years, our 10-year real return (net of inflation) expectation for US equities has hovered around 1% a year.

Our models, of course, do not include a pandemic factor. They are based on market fundamentals that can be observed and on an assumption that certain market variables, such as valuation multiples, cannot rise or fall forever; in other words, we believe that the largest and most persistent investment opportunity is long-horizon mean reversion.