Over the course of three speculative bubbles in the past 15 years, I’ve often made the distinction between “durable” investment returns and transient ones. At any point in time, the cumulative long-term return of the stock market equals the gain that investors can reasonably assume will be durable (in that it is unlikely to be surrendered in the future), plus whatever market gain investors should assume will be entirely wiped out over the course of the present or future market cycles. As it turns out, those two components can be identified with surprising accuracy.
We can understand the distinction between durable gains and transient gains by inspecting market history and asking this question: was the prevailing level of the stock market (or its cumulative total return) observed again at a later date? We define that level as “durable” only if it was not observed again in the future. By contrast, a market gain that is subsequently wiped out over the completion of the market cycle is clearly transient in hindsight.
Can investors identify the difference before the fact?
The chart below shows the S&P 500 Index (blue line) along with the “durable” portion of market gains in data since 1940 (red line). In cycles prior to the half-cycle advance since 2009, the level of the S&P 500 is identified as durable if the market never traded lower at any point in the future. The green line shows the estimated historical valuation norm of the S&P 500 on the basis of MarketCap/GVA (nonfinancial market capitalization / corporate gross value added). The values from 1940 to 1947 are imputed based on the average relationship between GVA and nominal GDP. For a reminder of how strongly this measure is related to actual subsequent market returns, see When You Look Back On This Moment In History.
Notice that the red line of durable S&P 500 market levels is almost invariably below the green line representing historical valuation norms. This demonstrates one of the central lessons of value-conscious investing: durable market gains are associated with market advances toward historically normal valuations, while transient market gains are associated with market advances that move beyond historically normal valuations. Because of that historical regularity, the “durable” threshold after 2009 is shown at the present valuation norm, and is unlikely to exceed that level, which is roughly half of the current level of the S&P 500.
[Geek's Note - For any given valuation metric X with historical norm Xn, the corresponding valuation norm for the S&P 500 at any point in time is simply the current S&P 500 level * Xn/X]
I should mention that if the S&P 500 was to decline below its 2009 trough, the long red line extending from 1996 to 2009 would have to be redrawn. Such a loss would imply significant undervaluation, while a retreat to current valuation norms (somewhere in the 940-1030 range on the S&P 500, based on the most historically reliable metrics) would represent an ordinary, run-of-the-mill outcome for the completion of the current market cycle given present valuations. We certainly don’t rely on a 50% market loss, but we should absolutely allow for it.
In this context, it should not be terribly surprising that the 2000-2002 market decline wiped out the entiretotal return of the S&P 500 – in excess of Treasury bill returns – all the way back to May 1996, or that the 2007-2009 decline wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to June 1995. Those losses were already baked in the cake. Of course, a decline below historically normal valuation can restrain market returns for a much longer period. The fact that the 1982 low for the S&P 500 was within 10% of the 1966 high was the result of a move from secular overvaluation to secular undervaluation over that 18-year period, even though the level of overvaluation in 1966 was nowhere near present levels.
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