Repricing a Market Priced for Zero

Having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated.

– Ben Bernanke, Federal Reserve Chair, January 3, 2010

Buckle up, buttercup.

The most challenging financial event for investors in the coming decade will be the repricing of securities to valuations that imply adequate long-term returns, following more than a decade of reckless and intentional Fed-induced yield-seeking speculation.

The chart below updates the status of our most reliable stock market valuation measures, based on their correlation with actual subsequent S&P 500 total returns in market cycles across history. Their historical profiles are largely indistinguishable. The arrow shows the current level of valuation, which remains above every valuation extreme observed prior to 2020. Indeed, our Margin-Adjusted P/E (MAPE), for which a century of data is available, remains beyond its 1929 peak.

Each measure is shown as a ratio to the historical norm associated with run-of-the-mill subsequent S&P 500 total returns of 10% annually. To say that recent market highs approached 3.6 times those historical norms is essentially to say that average S&P 500 total returns are likely to be nowhere near 10% annually during the coming 10-20 years.

Indeed, measured from the recent market peak, I expect S&P 500 total returns to be negative, on average, for well over a decade – an outcome I also projected at the 2000 market peak. That said, if a steep market decline was to front-load those losses, investors could also enjoy prospects for satisfactory long-term returns even a year or two from now. It’s current valuation extremes, and the dismal long-term returns they imply, that long-term investors may want to think twice about locking in.

Meanwhile, be careful not to interpret valuations as near-term market forecasts. That’s not how valuations work. The main thing that determines whether an overvalued market continues to advance, or drops like a rock instead, is whether investor psychology is inclined toward speculation or risk-aversion. When investors are inclined to speculate, they tend to be indiscriminate about it. When investors become risk-averse, they tend to be skittish and selective. For that reason, our most reliable gauge of speculation versus risk-aversion is the uniformity or divergence of market internals – across thousands of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness.