As Graham and Dodd wrote in Security Analysis (1934), referring to the final advance that led to the 1929 market peak, the reason investors shifted their attention away from historically -
reliable measures of valuation was «first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.»
The recent market cycle has extended much further, but it has also brought the most historically
reliable measures of valuation to obscene levels.
Although Wall Street continues to assert that valuations are «reasonable given the level of interest rates,» keep in mind that the most
reliable measures of valuation imply negative 10 - 12 year total returns for the S&P 500.
This does not, for even a moment, change the fact that the most
reliable measures of valuation are now an average of 3.0 times their historical norms.
Not exact matches
Moderate interest rates were associated with a whole range
of subsequent returns over the following decade, and we know that those outcomes were 90 % correlated with the level
of valuations at the beginning
of those periods (on
reliable measures such as market cap / GDP, price / revenue, Tobin's Q, the margin - adjusted Shiller P / E, and others we've presented over time - see Ockham's Razor and the Market Cycle).
There will always be conceptual issues with any single
valuation measure, so the best we can do is evaluate
valuations from the standpoint
of multiple historically
reliable approaches.
The economic gains and market returns that emerged during the Reagan Administration began from a starting point
of 10.8 % unemployment, a current account surplus, and market
valuations that - on the most historically
reliable measures - were less than one - quarter
of present levels.
None
of that would even require the most historically
reliable valuation measures to break below their pre-bubble norms.
With the S&P 500 within about 8 %
of its highest level in history, with historically
reliable valuation measures at obscene levels, implying near - zero 10 - 12 year S&P 500 nominal total returns; with an extended period
of extreme overvalued, overbought, overbullish conditions replaced by deterioration in market internals that signal a clear shift toward risk - aversion among investors; with credit spreads on low - grade debt blowing out to multi-year highs; and with leading economic
measures deteriorating rapidly, we continue to classify market conditions within the most hostile return / risk profile we identify — a classification that has been observed in only about 9 %
of history.
We've long argued, and continue to assert, that the most historically
reliable measures of market
valuation are far beyond double their historical norms.
The essential thing to understand about
valuations is that while they are highly
reliable measures of prospective long - term market returns (particularly over 10 - 12 year horizons), and
of potential downside risk over the completion
of any market cycle,
valuations are also nearly useless over shorter segments
of the market cycle.
Historically -
reliable valuation measures are remarkably useful in projecting long - term and full - cycle market outcomes, but the behavior
of the market over shorter segments
of the market cycle is driven by the psychological inclination
of investors toward speculation or risk - aversion.
Even if the growth rates
of nominal GDP and U.S. corporate revenues (including foreign revenues) over the coming 20 years match their 4 % growth rate
of the past 20 years, and even if the most
reliable valuation measures merely touch their historical norms 20 years from today, the S&P 500 Index two decades from now will trade more than 20 % lower than where it trades today.
These
measures include the S&P 500 price / revenue ratio, the Margin - Adjusted CAPE (our more
reliable variant
of Robert Shiller's cyclically - adjusted P / E), and MarketCap / GVA — the ratio
of nonfinancial market capitalization to corporate gross value - added, including estimated foreign revenues — which is easily the most
reliable valuation measure we've ever created or tested, among scores
of alternatives.
By March 2000, on the basis
of historically
reliable valuation measures, I projected that a retreat to normal
valuations would require an -83 % plunge in tech stocks.
The most
reliable measures of individual stock
valuation we've found are based on formal discounted cash flow considerations, but among publicly - available
measures we've evaluated, price / revenue ratios are better correlated with actual subsequent returns than price / earnings ratios (though normalized profit margins and other factors are obviously necessary to make cross-sectional comparisons).
While we prefer to compare market capitalization with corporate gross value added, including estimated foreign revenues, the following chart provides a longer historical perspective
of where
reliable valuation measures stand at present.
Recent cycles provide no evidence
of deterioration in the relationship between
reliable valuation measures (particularly those that aren't highly sensitive to fluctuations in profit margins) and actual subsequent market returns.
Don't criticize historically
reliable valuation measures that have maintained the same tight relationship with actual subsequent 10 - 12 year market returns that they've demonstrated across a century
of history.
Despite my admitted stumble in the half - cycle since 2009, it's perplexing that the equity market is at the second greatest
valuation extreme in the history
of the United States, on what are objectively the most durably
reliable valuation measures available, but it has somehow become an affront to suggest that this will not end well.
Our actual expectation is that the completion
of the current market cycle is likely to wipe out the entire total return
of the S&P 500 — in excess
of Treasury bill returns — all the way back to roughly October 1997; an outcome that would require a market retreat no larger than it experienced in the past two cycles, and that would not even carry historically
reliable valuation measures to materially undervalued levels (see When You Look Back On This Moment In History).
On the basis
of the most
reliable valuation measures we identify (those most tightly correlated with actual subsequent 10 - 12 year S&P 500 total returns), current market
valuations stand about 140 - 165 % above historical norms.
Again, if our
measures of market internals were to improve, we would allow for the possibility that
reliable measures of market
valuations could surpass their 2000 extreme, and we would not place a «cap» on how high stock prices could move.
On a wide range
of historically
reliable measures (having a nearly 90 % correlation with actual subsequent S&P 500 total returns), we estimate current
valuations to be fully 118 % above levels associated with historically normal subsequent returns in stocks.
Last week, the most historically
reliable equity
valuation measures we identify (having correlations
of over 90 % with actual subsequent 10 - 12 year S&P 500 total returns) advanced to more than double their
reliable historical norms.
Currently, the S&P 500 would have to decline by about 55 % simply to price out at historically run -
of - the - mill
valuations on the most
reliable measures.
As a result, the most historically
reliable valuation measures now suggest that the S&P 500 will experience a net loss over the coming decade, while including broader (if slightly less
reliable)
measures results in projected S&P 500 10 - year annual nominal total returns
of about 1.4 % annually (see Ockham's Razor and the Market Cycle for the arithmetic behind these estimates).
Both benefit from solid
valuation methods and
reliable measures of market action, but investment weighs
valuation more strongly, while speculation weighs market action more strongly.
Suppose we
measure valuation by comparing price P to some
measure of earnings E that isn't distorted by cyclical economic fluctuations, and can be used as a
reliable, representative, «sufficient statistic» for long - term cash flows.
Note that on the basis
of this
measure, expected 12 - year S&P 500 total returns associated with current
valuation levels are negative, and even if one was to shift the blue line up somewhat closer to the red line in recent years, the associated return expectation would still be close to zero (which is what I actually expect based on MarketCap / GVA and other historically
reliable measures).
That outcome would not even take our most
reliable valuation measures below historical norms that they've approached or breached by the end
of every market cycle in history.
Despite my admitted stumble in the half - cycle since 2009, it's perplexing that the equity market is at the second greatest
valuation extreme in the history
of the United States, on what are objectively the most durably
reliable valuation measures available, but it has somehow become an affront to suggest that this will not end well.
Our actual expectation is that the completion
of the current market cycle is likely to wipe out the entire total return
of the S&P 500 — in excess
of Treasury bill returns — all the way back to roughly October 1997; an outcome that would require a market retreat no larger than it experienced in the past two cycles, and that would not even carry historically
reliable valuation measures to materially undervalued levels (see When You Look Back On This Moment In History).