With the most historically reliable
valuation measures about 2.8 times their historical norms, these extreme starting valuations are worth considering here.
Not exact matches
Because when you actually look at the relationship across sectors, and you look at their
valuations based on return on equity, or other
measures, all sectors seem to be
about fairly valued.
While a number of simple
measures of
valuation have also been useful over the years, even metrics such as price - to - peak earnings have been skewed by the unusual profit margins we observed at the 2007 peak, which were
about 50 % above the historical norm - reflecting the combination of booming and highly leveraged financial sector profits as well as wide margins in cyclical and commodity - oriented industries.
At Berkshire Hathaway's recent annual shareholders meeting, an investor asked Buffett
about the relevance of two popular
measures of stock market value: 1) market cap - to - GDP, which Buffett once heralded as «probably the best single
measure of where
valuations stand at any given moment» and 2) the cyclically - adjusted price - earnings ratio (CAPE), which was made famous by Nobel prize winner Robert Shiller and was seen as accurately predicting the dot - com bubble and the housing bubble.
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.
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.
At present, the
valuation measures we find most strongly correlated with actual subsequent S&P 500 total returns suggest zero total returns for the S&P 500 over the coming 10 years, and total returns averaging only
about 1 % annually over the coming 12 - year period.
Nolte added that despite concerns
about the
valuation of the FAANG stocks, something he noted has persisted for years with little impact on the stock prices, the group's prospects remained strong by many
measures.
As usual, I don't place too much emphasis on this sort of forecast, but to the extent that I make any comments at all
about the outlook for 2006, the bottom line is this: 1) we can't rule out modest potential for stock appreciation, which would require the maintenance or expansion of already high price / peak earnings multiples; 2) we also should recognize an uncomfortably large potential for market losses, particularly given that the current bull market has now outlived the median and average bull, yet at higher
valuations than most bulls have achieved, a flat yield curve with rising interest rate pressures, an extended period of internal divergence as
measured by breadth and other market action, and complacency at best and excessive bullishness at worst, as
measured by various sentiment indicators; 3) there is a moderate but still not compelling risk of an oncoming recession, which would become more of a factor if we observe a substantial widening of credit spreads and weakness in the ISM Purchasing Managers Index in the months ahead, and; 4) there remains substantial potential for U.S. dollar weakness coupled with «unexpectedly» persistent inflation pressures, particularly if we do observe economic weakness.
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.
Based on the
valuation measures most strongly correlated with actual subsequent total returns (and those correlations are near or above 90 %), we continue to estimate that the S&P 500 will achieve zero or negative nominal total returns over horizons of 8 years or less, and only
about 2 % annually over the coming decade.
On
valuation measures most strongly correlated with actual subsequent S&P 500 nominal total returns, we presently expect negative total returns for the S&P 500 on a 10 - year horizon, and total returns averaging only
about 1 % annually over the coming 12 - year period (chart).
As I've noted in recent weeks (see in particular the March 27 comment, my assertion that stocks are
about double their normal historical
valuations also applies to earnings - based
measures like P / E ratios.
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).
On a stock selection basis, favorable
valuation and market action on our
measures are certainly not always rewarded, but that's why we diversify across
about 200 individual holdings.
«Professor Shiller's P / E10
measure of stock
valuations tells us
about the market as a whole.
After thinking
about these ideas, I went to the internet and began searching for a way to
measure relative
valuations and get some historical context.
Again, I am most concerned
about the combination of unfavorable
valuation and unfavorable market action, including the breakdown in market internals and trend - following
measures, immediately following an extended period of overvalued, overbought, overbullish conditions and other hostile syndromes.
While we often have very strong views
about long - term and full - cycle market outcomes (based on
valuation measures that we find strongly correlated with those outcomes in market cycles across history), we rarely have pointed short - term market expectations.
If you are to make really big money in the stock market, resign yourself to the fact that just
about everything you buy, if you are buying stocks correctly, will seem too high priced by just
about any traditional
measure of
valuation.
Inputs refer broadly to the assumptions that market participants would use in pricing the asset or liability, including assumptions
about risk, for example, the risk inherent in a particular
valuation technique used to
measure fair value including such a pricing model and / or the risk inherent in the inputs to the
valuation technique.