One of the things that some forget is that we shifted to a constructive stance between those two crashes in early 2003, and initially moved toward a constructive stance after the market collapsed in late-2008 (see Why Warren Buffett is Right and Why Nobody Cares) until a parade of policy errors forced us to entertain Depression-era outcomes. My 2009 stress-testing miss and the awkward transition that resulted certainly injured my reputation during this uncompleted half-cycle. Still, having addressed that “two data sets” problem, I expect no similar stress-testing response in future market cycles. Meanwhile, I have every expectation that the current speculative extremes will end in tears for those inclined to dismiss hard, historically reliable evidence by mumbling “permabear.” On the bright side, the conclusion of the present cycle and the course of those that follow are likely to provide strong, extended opportunities to take aggressive investment exposure. Now would just be a particularly inopportune moment to do so.
Extraordinary market returns and dismal market returns both come from somewhere. Long periods of outstanding market returns have their origins in depressed valuations. Long periods of dismal market returns have their origins in elevated valuations. The best way to understand the returns that investors can expect over the long-term is to have a firm understanding of where reliable measures of valuation stand at each point in time.
A few quick valuation studies may be helpful. As the workhorse for these studies, we'll use the ratio of market capitalization to GDP. Warren Buffett (Trades, Portfolio) observed in a 2001 Fortune interview that "it is probably the best single measure of where valuations stand at any given moment."
A variety of normalized earnings measures could be used as well, but emphatically, what should not be used is any price/earnings measure that is not adjusted for the variation of profit margins over the economic cycle. That includes the "Fed Model" and any number of "equity risk premium" measures, which actually have a rather weak correlation with actual subsequent market returns. For more evidence on why margin variation is important to consider, see Margins, Multiples, and the Iron Law of Valuation.
Quick Valuation Study: 1950
In 1950, the ratio of market capitalization to GDP was at 0.40, while the dividend yield on the S&P 500 was 6.7%. Over the next decade, nominal GDP would grow by about 6.3% annually, and the ratio of market cap to GDP would increase to its (pre-bubble) historical norm of 0.63. As a result, the S&P 500 would go on to post total returns averaging nearly 18% annually over the following decade.
Stay with me here. It’s critical to understand the basic arithmetic behind those outstanding market returns.
The capital gains portion of that annual return was driven by two pieces: the growth in nominal GDP, and the reversion in the ratio of market capitalization to GDP toward its historical norm. Given the numbers above, that piece comes out to:
(1+nominal GDP growth)*(normal MCAP/GDP ratio / actual MCAP/GDP ratio)^(1/10) – 1.0
(1.063)*(0.63/0.40)^(1/10) – 1.0 = 11.2% annually for capital gains
Now add in the 6.7% dividend yield, and you’ve got – not surprisingly – 17.9% annually.
Quick Valuation Study: 1982
Let’s try that again. In 1982, the ratio of market capitalization to GDP had fallen to 0.35, while the dividend yield on the S&P 500 had again soared to 6.7%. Nominal GDP growth over the following decade would remain close to its historical average peak-to-peak growth rate across economic cycles, roughly 6.3% annually.
Assuming long-term mean-reversion in the ratio of market cap to GDP, what might you have expected the annual total return of the S&P 500 to be, in the decade following the 1982 low? Do the math:
(1.063)*(0.63/0.35)^(1/10) – 1.0 + 0.067 dividend yield = 19.4% annually.
That estimate would have been almost precisely correct. While small variations in GDP growth and dividend yield can change that basic math in a small, fairly linear way, the main factor behind the outstanding total returns in the decade following the 1982 low was the remarkably depressed initial valuation of the market, reflected by the market capitalization to GDP ratio, and the gradual reversion toward less extreme valuations over a period of years.
Quick Valuation Study: 2000
In early 2000, the ratio of market capitalization to GDP reached the highest level in history, at 1.54, while the dividend yield of the S&P 500 was just 1.1%. At that point, a reasonable estimate of subsequent 10-year total returns for the S&P 500 would have been:
(1.063)(0.63/1.54)^(1/10) – 1.0 + .011 = -1.7% annually.
That is just what we were saying in 2000: negative total returns for a decade. Those concerns were predictably shrugged off, as they are today. But in fact, the S&P 500 lost value exactly as expected. Importantly, this outcome was not simply an artifact of the 2008-2009 market decline. By early 2010, when that 10-year period ended, the S&P 500 was already 80% above its March 2009 low (in hindsight thanks to the March 2009 change to accounting rule FAS 157), yet had still posted a negative 10-year total return. The actual total return of the S&P 500 from 2000 to the 2009 low was considerably worse than -1.7% annually.
Quick Valuation Study: 2000 to 2014
Let’s take a slightly longer horizon, from 2000 until today. A 14-year estimate of total returns from the 2000 peak would change only one thing in the equation above, which is the number of years. The estimate from 2000 to the present would have been:
(1.063)(0.63/1.54)^(1/14) – 1.0 + .011 = 0.8% annually.
As it happens, the S&P 500 has achieved a greater return over these past 14 years. In fact, the annual total return has averaged 3.5% annually. Moreover, the market has squeezed out this higher rate of return even though the actual growth rate for nominal GDP since 2000 has averaged just 3.9% instead of the historical peak-to-peak growth rate of 6.3% annually.
Why have market returns been able to average even 3.5% over the past 14 years? Simple. Valuations have been pushed, once again, to some of the highest levels in history. Instead of terminating this 14-year period anywhere near historical norms, the ratio of market capitalization to GDP presently stands at 1.25, which is double its historical norm.
Here’s another way to understand this outcome. Considering both the overshoot of returns and the undershoot of nominal GDP growth, one would have expected the total return of the S&P 500 over the past 14 years to be 5.1% lower than we’ve actually observed (0.8% - 3.5% + 3.9% - 6.3%). Compounding a 5.1% overshoot for 14 years now places valuations at double their historical norm.
Importantly, this level of overvaluation isn't simply true for market capitalization to GDP, but for a variety of other historically reliable measures that have a roughly 90% correlation with actual subseqeuent market returns (see It is Informed Optimism to Wait for the Rain).
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