Despite extreme valuations, investors’ fear of missing out is looking increasingly desperate. In market cycles across history, that has been an unfortunate impulse.
One way to use information on stock valuations and interest rates in a systematic way is to estimate the break-even level of valuation that would have to exist at given points in the future, in order for stocks to outperform or underperform bonds over various horizons. Investors presently face a dismal menu of expected returns regardless of their choice. Indeed, in order for expected S&P 500 total returns to outperform even the lowly return on Treasury bonds in the years ahead, investors now require market valuations to remain above historical norms for the next 22 years.The good news is that this menu is likely to improve substantially over the completion of the current market cycle. The problem is that current valuation extremes present a hostile combination of weak prospective return and steep risk.
One of the benefits of historically-informed investing is that it allows various investment perspectives to be evaluated from the standpoint of evidence rather than verbal argument. That’s particularly important during periods like today, when much of financial commentary on Wall Street can be filed into a folder labeled “it’s hard to argue with your logic, if only your facts were actually true.”
Put simply, investors are in an echo chamber here, where their optimism about economic outcomes is largely driven by optimism about the stock market, and optimism about the stock market is driven by optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list.
Imagine driving a car moving down the road at 20 miles an hour. You hold a rope out the window. At the other end of that rope is a skateboard. If the skateboard is behind the car, yanking the rope pulls the skateboard forward, so the skateboard might temporarily speed ahead until it gets way ahead of the car and the rope tightens again.
Over the completion of the current market cycle, we estimate that roughly half of U.S. equity market capitalization - $17 trillion in paper wealth - will simply vanish. Nobody will “get” that wealth. It will simply disappear, like a game of musical chairs where players think they've won by finding chairs as the music stops, and suddenly feel them dissolving as if they had never existed in the first place.
Presently, based on the most historically reliable valuation measures we identify, we expect annual total returns for the S&P 500 averaging just 0.6% over the coming 12-year period; a prospective return that we expect will not only underperform bonds over this horizon, but even the lowly yields available on risk-free T-bills.
During the later part of the roaring 20’s, Irving Berlin wrote “Blue Skies,” which captured some of the optimism of the era that preceded the Great Depression. Unfortunately, untethered optimism is not the friend of investors, particularly when they have already committed their assets to that optimism, and have driven valuations to speculative extremes.
"The issue is no longer whether the current market resembles those preceding the 1929, 1969-70, 1973-74, and 1987 crashes. The issue is only - are conditions like October of 1929, or more like April? Like October of 1987, or more like July?
As Benjamin Graham observed decades ago, "Speculators often prosper through ignorance; it is a cliche that in a roaring bull market, knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss."