When there is a discussion of low future returns due to valuations, what gets missed is that such requires a bear market.
Let me explain.
In “Do You Feel Lucky,” Michael Lebowitz compiled a series of valuation metrics and their correlation to future returns. To wit:
“The average of the 10-year expected returns from the four gauges is -0.75%. When the Fed backs off, whether by its design or due to inflation, slower economic growth, or massive debt overhead, rich valuations will matter.”
The mistake many investors make is assuming that such means every year, over the next decade, returns will be near zero. As we will discuss, it is not every year, but one or two awful years, impacting the whole.
Fun With Math
The vital point to understand is that over the long-term investing period, “value” and “returns” are both inextricably linked and opposed. As shown above, forward return expectations are lower than the long-term average given current valuation levels.
Let’s review what “low forward returns” does and does not mean before looking at different valuation measures.
- It does NOT mean the stock market will have annual rates of return of sub-3% each year over the next 10-years.
- It DOES mean the stock market will have stellar gains in some years, a big crash somewhere in between, or several smaller ones, and the average return over the decade will be low.
“This is shown in the table and chart below which compares a 7% annual return (as often promised) to a series of positive returns with a loss, or two, along the way. (Note: the annual average return without the crashes is 7% annually also.)”
“From current valuation levels, two-percent forward rates of return are a real possibility. As shown, all it takes is a correction, or crash, along the way to make it a reality.”
Such isn’t a prediction; it is just statistical probability and simple math.