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.
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We saw an unfortunate bit of analysis circulating last week, imagining that concerns about extremely elevated corporate profits (relative to revenues, GDP, GNP, and national income – all of which happen to produce nearly identical conclusions) simply reflect a failure to use the correct divisor.
Intending to support the "incorrect denominator" argument, the following chart was presented, (which took a bit of data forensics to replicate, for reasons that will be apparent shortly). The chart still suggests that profit shares are high relative to history, but not to the extreme that other research (including our own) suggests. The lines were labeled “National profits / national income”, with the top line as “Total”, the second line “From U.S.” and the third line “From abroad.”
The problem is that the analyst’s conclusion that profit shares are just fine has absolutely nothing to do with the distinction between national income and domestic income (using either denominator would produce the same graph). Despite claims that this distinction drives the results, the entire analysis is actually driven by the fact that pre-tax profits have been inadvertently used in the numerators. Meanwhile, the analyst has inexplicably opted to use net national income in the denominator, which subtracts out depreciation (consumption of fixed capital or CFC) of fixed private investment and government gross investment. This causes the resulting income figure to diverge from both GDP and GNP in a way that does little but introduce additional noise.
