Current market valuations are consistent with negative expected returns for the S&P 500 over the coming 10-12 years, with a likely market loss of more than -60% in the interim. The proposition that “lower interest rates justify higher valuations” has become a rather dangerous slogan, and is a distressingly incomplete statement that ignores the other half of the sentence: “provided that the stream of expected cash flows is held constant.”
The present moment of blissful delusion is remarkable to witness. Take it in. A few words and updated charts will do.
So the mindset, I think, goes something like this. Yes, market valuations are elevated, but, you know, low interest rates justify higher valuations. Besides, there’s really no alternative to stocks because you’ll get what, 1% annually in cash? Look at how the market has done in recent years. There’s no comparison.
At the October 2002 market low, the S&P 500 stood -49.2% below its March 2000 peak (-48.0% including dividend income), with the Nasdaq 100 having lost more than -82.8% from its high, on the basis of both price and total return. The loss wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996.
The main contributors to the illusion of permanent prosperity have been decidedly cyclical factors. Investors presently appear to be taking past investment returns and economic growth at face value, without considering their underlying drivers at all. My impression is that while the U.S. may very well encounter credit strains or other economic dislocations in the coming years...
Current extremes present what I view as one of the three most important opportunities in history to defend capital. My sense is that many investors will squander this opportunity until yet another bubble implodes.
The belief that Fed-induced speculation creates “wealth” is a conceit that rests on the delusion that “wealth” is embodied in the price of an asset, rather than the stream of cash flows it delivers over time.
Within a small number of years, investors are likely to discover that they have allowed their assumptions about growth in U.S. GDP, corporate revenues, earnings, and their own investment returns to become radically misaligned with reality, and that Wall Street’s justifications for the present, offensive level of equity market valuations are illusory. Based on outcomes that have systematically followed prior valuation extremes, the accompanying adjustment in expectations is likely to be associated with one of the most violent market declines in U.S. history, even if interest rates remain persistently depressed.
We extract signals about the preferences of investors toward speculation or risk-aversion based on the joint and sometimes subtle behavior of numerous markets and securities, so our inferences don't map to any short list of indicators. Still, internal dispersion is becoming apparent in measures that are increasingly obvious.
In my view (supported by a century of market cycles), investors are vastly underestimating the prospects for market losses over the completion of this cycle, are overestimating the availability of “safe” stocks or sectors that might avoid the damage, and are overestimating both the likelihood and the need for some recognizable “catalyst” to emerge before severe market losses unfold.