The Return of Buy-Low Sell-High

"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. Measured from the recent bubble peak, the likely consequence will be a long, interesting, 10-20 year trip to nowhere for the S&P 500. There’s also a strong possibility of an interim loss in the S&P 500 in the range of 50-70% over the completion of this market cycle, or as we observed between 2000-2009, a sequence of cyclical lows punctuated by several extended recoveries. 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.

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. The most severe market losses tend to emerge when elevated valuations are joined by deterioration and divergence in market internals, suggesting risk-aversion among investors. Conversely, the strongest opportunities tend to emerge when a material retreat in valuations is joined by broad uniformity in market internals, suggesting speculative psychology among investors.”

– John P. Hussman, Ph.D., Repricing a Market Priced for Zero, April 29, 2022

The S&P 500 is two years into what we expect to be a very long, interesting trip to nowhere. The strongest stock market returns in the coming decade, perhaps longer, are likely to emerge during advances in the S&P 500 that attempt to catch up with the cumulative return of risk-free Treasury bills. Recall that investors experienced the same outcome between 1929-1947, 1968-1985, and 2000-2013, all periods when the total return of the S&P 500 lagged the return of Treasury bills for well over a decade.

The reason we expect the same outcome from the 2022 market peak as we did from the peaks in 1929, 1968, and 2000 is simple: extreme valuations produce dismal long-term outcomes. As I’ve detailed across decades of market cycles (see for example, Making Friends with Bears Through Math), this is not simply a theory. It is arithmetic. Investors are clearly not interested in this arithmetic, for now.

After the 1929-1932 market collapse, Graham & Dodd detailed the arguments that had lulled investors to turn their attention away from valuations in favor of passive investing: “This gospel was based on a certain amount of research, showing that diversified lists of common stocks had regularly increased in value over stated intervals of time for many years past… It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.” Today, investors have again abandoned concern about valuations, embracing “passive” strategies in the belief that losses will always be recovered quickly.

The chart below shows the valuation measure we find best-correlated with actual subsequent returns in market cycles across history: the ratio of nonfinancial market capitalization to gross value-added, including estimated foreign revenues (MarketCap/GVA). The current level is 2.9, slightly below the 2022 record, but higher than any level observed prior to 2021, except for a 12-week period surrounding the 1929 peak. It’s worth noting that historically, a level of about 1.0 has been associated with run-of-the-mill subsequent S&P 500 total returns of about 10% annually. That’s about 65% below current levels. Even restricting the data to the period since the late-1990’s, the level associated with subsequent 10% annual returns is only about 1.2 (see the section titled “You may not like this part” in The Structural Drivers of Investment Returns).

Nonfinancial Market Capitalization