We continue to observe one of the most overvalued, overbought, overbullish syndromes in the historical record, combined – and this feature is central – with deterioration in market internals suggestive of a shift toward risk-averse preferences among investors. The resulting combination places current conditions among instances that we identify as a “Who’s Who of Awful times to Invest” (see last week’s comment:Plan to Exit Stocks in the Next 8 Years? Exit Now). Based on historical outcomes associated with those prior instances (which prior to the current market cycle, include only 1929, 1972, 1987, 2000 and 2007), we continue to view the stock market as vulnerable to significant downside risk both in the near-term and over the completion of the present market cycle.
There is a critical element to these concerns, however, that forms the central distinction between episodes in history where overvalued markets continued higher, and episodes that quickly became vulnerable to free-falls and crashes. That element is the condition of investor preferences toward risk, which we infer from the uniformity or divergence of market internals, credit spreads and other risk-sensitive factors. A broad improvement in market internals on our measures would not relieve the obscene overvaluation of the equity market, but it would suggest a return to speculative investor preferences and would reduce the immediacy of our downside concerns.
We cannot rule out the possibility of market advances counter to the hostile market return/risk profile we presently identify, as even the most hostile profile we identify has included instances of advancing prices. Our concern here is that the average historical outcome of similar conditions has been dismal – typically including a steep market loss over a period of about 10 weeks, and invariably followed by extensive losses over the completion of the market cycle. This instance may be different in the near term, but a century of evidence argues that the completion of the market cycle will wipe out the majority of the gains observed in the advancing portion to-date (even without valuations similar to the present, the average, run-of-the-mill bear market decline has erased more than half of the market gains from the preceding bull market advance).
Our investment strategy is decidedly focused on the complete market cycle. For investors committed to a passive buy-and-hold discipline over a much longer horizon; who anticipate and can tolerate the 30-50% losses that can emerge over the completion of the market cycle; who are well-diversified; who recognize that elevated valuations warrant lower long-term return expectations, and who have aligned the risk profile and duration of their portfolio with their expected future spending needs, my advice remains straightforward: maintain adherence to your discipline. Do everything necessary – as soon as possible – to ensure that these conditions are met, and use alternative assets to the extent that they contribute to your diversification, but stick to your discipline.
That said, what we’ve observed in prior cycles, especially during 2000 and 2007, is this. Investors often convince themselves to follow a buy-and-hold strategy only after lengthy market advances, and even raise their expectations about the level and safety of future returns at exactly the point where elevated valuations imply poor long-term market prospects (see A Warning from Graham and Dodd). They later abandon their buy-and-hold convictions after lengthy market declines. What I am urging is that investors vividly imagine realistic market losses ahead of time (the 2000-2002 and 2007-2009 declines each wiped out half of the stock market’s value, and the average run-of-the-mill cyclical loss exceeds 30%). One may believe that the timing of such losses is unpredictable, and that’s fine. The point is that such losses are the way that market cycles regularly conclude. Even Jack Bogle, for whom we have great respect, encourages investors to “prepare for at least two declines of 25-30 percent, maybe even 50 percent, in the coming decade.” That’s not a timing call. It’s simply historically informed realism. Particularly in light of current valuations, investors should set their portfolio allocations to allow for such risk without later abandoning their discipline if it becomes painful.
What does that difference mean?
The early weeks of 2015 are the first time in history that both 10-year Treasury yields and our estimates of prospective 10-year nominal total returns for the S&P 500 have both declined below 2% annually. Even at the 2000 peak, when our 10-year total return projections were negative, the 10-year Treasury yield was 6.8%, and small capitalization stocks showed reasonable value, particularly on a relative basis. Presently, long-term bonds provide nowhere to hide, and median equity valuations exceed those at the 2000 peak on price/earnings, price/revenue, and enterprise value/EBITDA. Because of yield-seeking speculation, stock and bond prices today are already where they are likely to be many years from today. Prices are likely to experience an interesting and volatile trip to nowhere in the interim.
We saw a noteworthy piece from an analyst named Jonathan Selsick last week. Essentially, Selsick examined the Shiller P/E (the S&P 500 divided by the 10-year average of inflation-adjusted earnings) and showed that the multiple is even better correlated with actual subsequent S&P 500 total returns using 16-year smoothing and a 16-year investment horizon. My impression is that this “Shiller 16” multiple is more effective than the 10-year version because it captures two effects:
1) Longer averaging in the earnings component of the indicator further reduces the cyclical variation in the underlying fundamental. We know that measures that are insensitive to cyclical profit margin variations (e.g. market cap/GDP, price/revenue) perform strongly over long horizons of ~10 years, and far better than popular, widely quoted measures that ignore those variations. For more on this regularity, see Margins, Multiples, and the Iron Law of Valuation.
2) By extending the projection horizon by an extra market cycle (~6 years –Â the current half-cycle is quite long in the tooth from a hisorical perspective) the effect of mean reversion has a greater chance to dominate the occasional noise that emerges (e.g., during the tech bubble) over shorter horizons. That said, there’s no particular reason that the smoothing horizon in the Shiller P/E needs to match the projection horizon. What drives the historical accuracy of this and similar valuation measures is that every market cycle in history, with the exception of the 2002 market low, has ended at valuations consistent with historically normal long-term expected returns of about 10% annually. So projection horizons that span the completion of at least one market cycle tend to be most effective. In fact, one can show that valuations tend to be best correlated with subsequent market returns over periods representing roughly 0.5, 1.5 or 2.5 typical market cycles (see my 2014 Wine Country Conference presentation, A Very Mean Reversion, for details).
Selsick estimates the relationship between the Shiller-16 and subsequent 16-year total returns in the S&P 500 and arrives at a 16-year estimate of prospective nominal returns of 4.94% annually. In my view, this estimate is probably quite close to the mark. One can relate this directly to a 10-year prospective return by recalling that historical tendency for market cycles to establish normal prospective returns – if even briefly as in 2009 – at their troughs (and it's typical for troughs to reach below average valuations and much higher prospective returns than the 10% historical norm). A decade is a long time, and much can change. I expect we'll see valuations at least touch historically normal levels at some point in the next decade, and of course, our 10-year prospective return estimates imply this.
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