Be prepared for awful stock returns over the next 5 years.

Authors note: Anything you see in any of my blog posts that is underlined is either a cool external link to help you learn more or internal links to my own related content.

 

I'll try to keep this post short, sweet, and accessible for both finance nerds and n00bs alike.

The last few years sure have been good for stocks...like REALLY REALLY good. We hit 2,872 on the S&P 500 index on January! The stock market's primary index has more or less doubled from where it were just before the 2008/09 financial crisis, and has more than quadrupled from where they were at the 2009 crisis bottom. The past few years have been abnormally good, relative to the economic performance of the 500 businesses whose earnings are the foundation of the S&P 500. But you don't care, because them dolla dolla bills just keep adding up!

While trying to wrap my mind around the recent stock market run-up, I created a pretty cool chart that attempts to take the last 80 years of stock market history and smooooooth it out. I wanted to take the highs and lows of the business cycle and the extremes of investor sentiment and make them less noisy.

So I took data on the index going back 80 years to 1938 and had some fun with it:

1) I took the real (inflation-adjusted) earnings of the S&P 500 and smoothed them out.

2) I took 9 year average PE ratios (valuation) and ranges within a standard deviation by year and smoothed that out as well.

3) I then multiplied together those (normalized earnings X normalized valuation) to get a normalized range of stock market prices by year. Finally, I overlaid the actual real (inflation-adjusted) S&P 500 prices from 1938-today, AND projected the trend data forward 10 years to 2028.

The resulting graph attempts to show the S&P 500 compared to what I call "normal-normal" range. Again, "normal-normal" to me basically means "Where the S&P 500 should be after smoothing out the wild swings in business cycles AND investor sentiment."

And here's my result and a link to the spreadsheet: 

I don't think i've seen the market visualized quite like this before

chart.png

Here's the same data viewed another way:

chart (1).png

I think my little charts do a pretty good job of summing up the gist of today's market conditions: the past few years of amazing stock returns have put us well above the "historically normal" zone. 

So what should our central expectation be for future stock returns over the next 0-5 years? In general, we should be fairly pessimistic. Investing today at these high prices only makes sense if you think historically normal business fundamentals and historically normal interest rates aren't coming back anytime soon.

These sentiments are echoed in a recent memo by famous investor Howard Marks:

"Most valuation parameters are either the richest ever (Buffett ratio of stock market capitalization to GDP, price-to-sales ratio, the VIX, bond yields, private equity transaction multiples, real estate capitalization ratios) or among the highest in history (p/e ratios, Shiller cycle-adjusted p/e ratio).  In the past, levels like these were followed by downturns.  Thus a decision to invest today has to rely on the belief that “it’s different this time.”

Here are links to some of those valuation metrics cited by Marks:

Buffett Indicator: Market cap to GDP

Price to Sales

Shiller PE Ratio

In addition to the valuation metrics and earnings data already shown, no musing on stock market valuations would be complete without a quick comment on interest rates. All else equal, lower interest rates increase asset prices and higher interest rates lower asset prices. The reason is because higher interest rates lower the equity risk premium and therefore make stocks relatively less attractive compared to bonds, but that's beyond the scope of this post. The bottom line is that after decades of falling, interest rates are starting to rise again.  If rates continue to go up, as they are expected to, this will put much greater pressure on stock valuations, and likely result in a significant drop in stock prices. Also, the yield curve is flattening  and that is a classic sign of that an economic expansion is moving towards a recession.

You know the cliche, "When something seems to good to be true, it probably is." As good as the recent gains have felt, the intelligent investor should be aware of the significant probability that much of the recent gains will turn out to be transient. Otherwise, you risk getting caught with your pants down like investors did in the Dot.Com bubble.

If my analysis is correct, what is the best course of action? Should you panic and sell your stocks? No! But, here are some things you may want to consider:

1) If you're highly leveraged, or have bought stocks on margin, consider reducing that risk.

2) If you have any other high interest debt (credit cards, etc), consider paying it off now (while you presumably have cash) before the next market downturn.

3) Possibly selling any stocks you own that appear to have appreciated way beyond their intrinsic value.

4) Being very conservative in making new investments, and possibly consider building up your cash percentage so that you will be prepared for the next crash or recession.

Otherwise, a correction or crash in stocks may leave you feeling like this kid....

Thanks for reading!

 

*The above references an opinion and is for information purposes only.  It is not intended to be investment advice.  Seek a duly licensed professional for investment advice.