Last week, the S&P 500 closed at a record high. Based on valuation measures that have maintained a nearly 90% correlation with subsequent 10-year total returns (not only historically, but also in more recent decades), we estimate that the S&P 500 is more than 100% above the level at which it would be priced to achieve historically normal returns in the coming years. Another way to say this is that at current prices, we estimatenegative total returns for the S&P 500 on horizons of 7-years and less, and nominal total returns for the S&P 500 averaging just 2.4% annually over the coming decade, with historically normal total returns thereafter. Needless to say, a steep intervening retreat in stocks could result in much stronger return prospects much, much sooner than 7-10 years from now.
The accompanying charts bring these estimates up to date. The first presents a broad range of reliable fundamentals versus their historical norms.
The next chart underscores the close relationship between these measures and actual subsequent market returns. The various models include properly estimated dividend income, and are detailed in a variety of prior weekly comments. The Tobin’s Q and revenue model are straightforward variants of the others. Given a prospective 2.4% total return for the S&P 500 over the coming decade (albeit with considerable risk of steep intervening losses), a 10-year bond yield near 2.6%, and the likelihood of depressed short-term interest rates in the foreseeable future, an evenly balanced portfolio of stocks, bonds and cash can be expected to achieve an average nominal total return of only about 2% annually over the coming decade from present valuations. We believe there will be numerous opportunities in the coming quarters and years to commit capital at significantly higher prospective returns and significantly diminished risk of capital loss. Investors, particularly equity investors, are gambling their financial future in a casino where the odds are increasingly against them.
On a valuation basis, stocks are far more overvalued than they were in October 1987, and less overvalued than they were in 2000, but both points warranted a strongly defensive stance because of the syndrome of conditions that emerged. Conversely, stocks were meaningfully overvalued in early 2003 when we shifted to a positive investment outlook, because market action was supportive and historically dangerous features were absent.Valuations alone have little bearing on what investors can expect from stocks over the next several weeks, months, or even quarters.
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