Following the market decline of recent weeks, historically reliable valuation measures remain roughly 80% to 90% above the norms that have been reached or breached by the completion of every market cycle in history, including recent cycles as well as market cycles prior to the 1960s, when bond yields were similarly low. Treasury yields were below 3% for about 30% of the past century, but the most historically reliable equity valuation measures have been higher than present levels in only about 2% of history, primarily around the 2000 market peak.
I emphasize the importance of using historically reliable valuation measures because there are certainly many popular valuation measures that appear less extreme, but that also have only moderate or weak correlations with actual subsequent market returns. The chart below presents the ratio of nonfinancial market capitalization to corporate gross value added (MarketCap/GVA) which has the strongest correlation with 10- to 12-year Standard & Poor's 500 total returns among any valuation measure we’ve studied.
The chart below presents MarketCap/GVA on an inverted log scale (blue), along with the actual subsequent S&P 500 nominal annual total return over the following 12-year period (red). The good news is that the recent market retreat brought the 12-year prospective S&P 500 total return toward 2.5% annually in nominal terms. If this seems low, recall that the 12-year nominal S&P 500 total return following the more extreme 2000 market peak was actually negative. Consider the recent retreat progress, but don’t imagine for a moment that it has gone a significant distance in resolving the distortion of years of yield-seeking speculation that the Fed provoked through its deranged policy of quantitative easing.
At present, market conditions join these extreme valuations with uniformly poor market internals, based on a broad range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness. Credit spreads spiked to fresh highs last week, and we’re increasingly concerned about the potential for negative events relating to European banks, where gross leverage ratios are a multiple of U.S. leverage ratios and credit default swap spreads have spiked upward.
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