From a long-term perspective, we believe that investors have a strong opportunity here to reduce equity risk near the peak of a market cycle that has reached the second-greatest overvaluation extreme in U.S. history (second only to the 2000 peak).
Among the valuation measures we’ve found most strongly correlated with actual subsequent Standard & Poor's 500 10- to 12-year total returns, market valuations have pushed to a level that is more than double their reliable historical norms. From these levels, we fully expect 10- to 12-year S&P 500 nominal total returns near zero, with negative real returns after inflation.
Notably, the completion of every market cycle in history has taken the most reliable equity valuation measures toward or below their historical norms – levels associated with subsequent total returns approaching 10% annually. That includes two cycle completions since 2000, as well as cycles prior to 1960 when interest rates regularly hovered near present levels.
After an unusually extended speculative half-cycle, we doubt that the completion of the present cycle will be any different. It has taken the third speculative bubble in 16 years to bring the nominal total return of the S&P 500 since March 2000 to just 3.6% annually. It is not an act of pessimism to reject the notion that investors are doomed, from here, to suffer permanently elevated valuations and permanently dismal long-term returns. No. It is an act of historically informed optimism.
From a shorter-term perspective, market conditions are more ambiguous. Our measures of market internals remain broadly unfavorable, but enthusiasm over yet another round of monetary intervention in Europe pushed the S&P 500 above its 200-day average last week, and credit spreads, though still wide, narrowed somewhat. At the same time, participation remains tepid, with fewer than 40% of individual stocks above their own respective 200-day averages, sponsorship is questionable, as evidenced by waning trading volume, and short-term conditions are clearly overbought.
While a market break of even a few percent would be sufficient to clarify the technical picture and restore a steeply negative market outlook, there’s just enough ambiguity to keep our near-term views a bit more neutral at present.
The chart below shows the ratio of market capitalization to corporate gross value added on an inverted log scale (blue line, left scale), and the actual S&P 500 nominal annual total return over the following 12-year period (red line, right scale). For a mathematical decomposition, see Rarefied Air: Valuations and Subsequent Market Returns, which details why subsequent total returns are so strongly correlated with the log valuation ratio, and why the effects of changing interest rates and fundamental growth systematically offset each other over a 10- to 12-year holding period.
Continue reading here.Â
