“During the latter stage of the bull market culminating in 1929, the public acquired a completely different attitude towards the investment merits of common stocks… Why did the investing public turn its attention from dividends, from asset values and from average earnings to transfer it almost exclusively to the earnings trend, i.e. to thechanges in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.
“Along with this idea as to what constituted the basis for common-stock selection emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment. This gospel was based on a certain amount of research, showing that diversified lists of common stocks had regularly increased in value over stated intervals of time for many years past.
“These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses that could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether or not it was a desirable purchase.
“The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis… An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.”
Benjamin Graham & David L. Dodd, Security Analysis, 1934
Fourteen years ago, the S&P 500 reached what still stands as its most overvalued point in history. At the time, on the basis of a variety of valuation measures, we projected negative 10-year total returns for the S&P 500 over the following decade, even under optimistic assumptions. The general arithmetic behind these estimates is detailed in Ockham's Razor and the Market Cycle. The ratio of market capitalization to GDP reached 1.54 in 2000, which also offered a reasonably good indication of likely prospective total returns for the index over the decade to come. A fairly simple rule-of-thumb using market capitalization to GDP is presented in The Federal Reserve’s Two-Legged Stool. In 2000, that rule-of-thumb estimate of prospective S&P 500 10-year nominal annual total returns would have been:
(1.063)(0.63/1.54)^(1/10) – 1.0 + .011 = -1.7% annually.
As is generally the case over time (though not always over short horizons), these estimates worked out swimmingly. By 2010, even after an 80% rebound from the March 2009 low, the S&P 500 had still posted a negative total return from its 2000 peak.
While investors presently dismiss the potential for valuations to remain well-correlated with actual subsequent market returns, and there’s no assurance that they will, the foregoing rule-of-thumb has historically had a nearly 90% correlation with S&P 500 nominal total returns over the following decade. The chart of this relationship (from the April 21 comment) is shown below. Note that secular valuation lows as we saw in 1949 and 1982 have generally occurred at levels that have implied near-20% annual 10-year total returns for the S&P 500. The 2009 low was certainly a great improvement from the 2000 extreme, bringing prospective 10-year returns to about 10% annually (and slightly higher on several other reliable valuation measures), but current valuations are no longer consistent with prospective 10-year returns anywhere near those levels.
At present, even assuming nominal GDP growth of 6.3% over the coming decade, the same estimate of prospective 10-year S&P 500 nominal annual total returns based on market capitalization to GDP works out to:
(1.063)(0.63/1.34)^(1/10) - 1.0 + .020 = 0.5% annually.
Based on a broader set of historically reliable valuation methods, our consensus estimate is closer to 1.5% annually. Given a dividend yield of 2% for the S&P 500, it follows that we expect the S&P 500 Index to be lower a decade from now than it is today.
A legendary value investor, Benjamin Graham, insisted that "operations for profit should be based not on optimism but on arithmetic." Careful arithmetic is important in order to resist the temptation to rely on what Graham called "some generalized statement, sound enough within its proper field, but twisted to fit the speculative mania." For example, many investors casually dismiss valuations today by parroting "lower interest rates justify higher valuations." But they do so without doing the associated arithmetic, and without recognizing that even those higher "justified" valuations will still be associated with poor subsequent equity returns. As I detailed in Optimism versus Arithmetic, if we assume that short-term interest rates will remain at zero for another 3-4 years instead of a more normal 4%, one can justify stock valuations 12-16% above where they otherwise might be. That 12-16% elevation would in turn shave about 4% annually from equity returns over that same 3-4 year perod. Unfortunately, the most reliable valuation measures we identify are more than double pre-bubble historical norms, so the "justified valuation" argument is exactly the sort of twisted statement that Graham warned about.
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