With the fresh high in the S&P 500 Index last week, our estimates of prospective 10-year S&P 500 nominal total returns have fallen below 1.8% annually. At shorter horizons and on historically reliable measures, our estimates of S&P 500 total returns are now negative at every horizon shorter than 8 years. Investors who feel that zero interest rate policy offers them “no choice” but to hold stocks are likely choosing to experience negative returns instead of zero. While millions of investors appear to have the same expectation that they will be able to sell before everyone else, the question “sell to whom?” will probably remain unanswered until it is too late.
Meanwhile, we should recognize that each additional year where short-term interest rates are held at zero (rather than a more normal level of about 4%) is actually worth only an increase in market valuation of that same 4%. This is basic arithmetic. To see this, suppose that 30-year zero-coupon bonds normally yield 3% more than risk-free Treasury bills. In a world of 4% Treasury bill yields, the riskier bonds would yield 7%, with a price of $13.14 assuming a face value of $100. If short-term yields were expected to be zero for two years, normalizing thereafter, investors would price the 30-year bonds to return just 3% for the first two years, then 7% thereafter. The price that would be consistent with that result is $14.18 (= 100/{(1.07)^28 * (1.03)^2}). Not surprisingly, that’s about 8% higher than the bond would be valued in the absence of two years of zero interest rate policy.
Now assume 5 years of zero interest rate policy. The associated impact would be to raise the bond price to $15.89, which is not surprisingly just over 20% higher than the bond would be valued at in a constant 4% world. The same arithmetic applies for equities, and can be demonstrated using any discounted cash flow approach.
In this context, the fact that historically reliable valuation methods imply negative total returns at every horizon shorter than 8 years does not simply reflect the expectation of 8 years of zero interest rate policy, but 8 years of zero interest rate policy combined with zero compensation for the substantial additional risk of holding equities. Assuming that a modest risk premium is appropriate for an asset class that has proven itself quite capable of repeatedly losing half of its value, current equity valuations are reasonable only if one assumes more than two decades of zero interest rate policy. Even in that case, “reasonable” would still imply commensurately low equity returns in the mid-single digits over the next two decades.
At a time when we should be pounding the table about risk, we are quietly stating our case. At this point even that is something of a lightning rod for disdain. As we observed after the 2000-2002 and 2007-2009 plunges, our concerns have a tendency to hold weight only after the fact (see Setting the Record Straight andThis Time is Different, Yet With the Same Ending to understand our experience in the half-cycle since 2009). There’s certainly no point in urging anyone to sell – doing so only means that some other poor investor would have to hold the bag over the completion of this cycle.
It’s an unfortunate situation, but much of what investors view as “wealth” here is little but transitory quotes on a screen and blotches of ink on pieces of paper that have today’s date on them. Investors seem to have forgotten how that works. Few are likely to realize that apparent wealth by selling, and those that do will essentially be redistributing it from the investors who buy. Meanwhile, don’t confuse time to sell withopportunity to sell. Trading volume remains quite tepid, and the majority of that volume represents existing owners exchanging what they hold rather than outright entry and exit. The investors who successfully leave the equity market at current valuations will exit through a needle’s eye.
Implied volatility in S&P 500 index options fell to just 10.3% last week, indicating enormous complacency about potential risk. I’ve noted before that extreme overvalued, overbought, overbullish conditions tend to feature “unpleasant skew”: the raw probability of an advance is typically greater than the probability of a decline, so the market tends to achieve a series of successive but fairly marginal new highs, which can feel excruciating for investors in a defensive position. The “skew” part is that while the raw probability favors an advance, the remaining probability often features vertical drops that can wipe out weeks or months of market gains in a handful of trading days. We’ve certainly seen an unusual persistence of overvalued, overbought, overbullish conditions without consequence in recent quarters, but it is notable that the implied skew in S&P 500 index options has soared. Indeed, the ratio of implied skew to implied volatility spiked to the highest level in history on Friday. Again, we’ll quietly state our case here, with an understanding that there is little use in waving our arms about.
Again, on a broad range of historically reliable measures, our estimate of 10-year S&P 500 nominal total returns is now less than 1.8% annually. That said, the most reliable measures actually project negative returns, but then, the most reliable measures are those that adjust most fully for cyclical variations in profit margins, and we are continually reminded that this time is different. The ratio of market capitalization to GDP, which Warren Buffett (Trades, Portfolio) (correctly) observed in a 2001 Fortune interview is “probably the single best measure of where valuations stand at any given moment” is now about 150% (not just 50%) above its pre-bubble norm, even imputing a rebound in Q2 GDP growth. Of course, Buffett also wrote "A group of lemmings looks like a pack of individualists compared with Wall Street when it gets a concept in its teeth" - which may explain why Wall Street seems so entranced with the concept of QE instead of actually doing the math. The ratio of market capitalization to GDP, presented below on an inverted scale, is beyond every point in history except for the final quarter of 1999 and the first two quarters of 2000.
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