Last week, the most historically reliable equity valuation measures we identify (having correlations of over 90% with actual subsequent 10- to 12-year Standard & Poor's 500 total returns) advanced to more than double their reliable historical norms.
When valuations have been near those historical norms, the S&P 500 has generally followed with average nominal total returns of about 10% annually. In contrast, current valuations are associated with expected 10- to 12-year total returns of about zero with negative expected returns on both horizons after inflation.
Now, in the context of low interest rates, some investors may view the prospect of zero total returns on stocks over the coming decade as reasonable and competitive. That’s fine, but understand that through most of the period prior to the 1960s, interest rates regularly visited levels similar to the present, yet these same measures of stock valuations typically resided at well below half of present levels.
In my view, investors who view current valuations as “justified relative to interest rates” are really saying that a decade of zero total returns on stocks is perfectly adequate compensation for the risk of a 45% to 55% market loss over the completion of the current market cycle – a decline that would historically be merely run-of-the-mill given current valuations, and that certainly cannot be precluded by appealing to low interest rates.
See, across history, prospective and realized returns on stocks have been nowhere near as correlated with the level of interest rates as investors seem to believe. Indeed, because the level of interest rates at any point in time is highly correlated with the level of nominal economic growth over the preceding decade, the relationship between starting valuations and actual subsequent S&P 500 nominal total returns is nearly independent of interest rates. That is, interest rate and growth effects tend to cancel out over the holding period. For historical evidence and mathematical formalization of this, see Rarefied Air: Valuations and Subsequent Market Returns.
Note that the argument is not that stock valuations themselves are independent of interest rates. Rather, once a given level of valuations is established, investors can read directly from those valuations what return they are likely to enjoy over the following 10- to 12-year period. The chart below shows this relationship using market capitalization to corporate gross value added (blue, on an inverted log scale) versus actual subsequent 12-year S&P 500 nominal total returns (red).
Put simply, my expectation is that investors will find 10 to 12 years from today that the relationship between valuations and actual subsequent market returns has played out exactly as it has across history. As a rough guide to how prospective returns will change over the completion of the current market cycle, we estimate that, in order to establish expected 10-year S&P 500 total returns of 5% annually, the S&P 500 would have to decline to the mid-1,500s. In order to establish 10% expected total returns, we estimate that a decline to the 1,000 level on the S&P 500 would be about right. Note that the completion of every market cycle across history has brought valuations toward or below levels consistent with 10% annual prospective returns.
