While stocks have gyrated in recent months, U.S. equities have performed incredibly well since the 2008 to 2009 financial crisis. Since those lows, the S&P 500 has gone on a tear, exploding over 200% in just seven years.
But is this all a mirage?
Is the party over?
Returns in recent years have far outpaced historical averages. For example, since 1900, the U.S. stock market has averaged real returns of only 6.5%. At least one major asset manager believes the best has already come.
GMO is one of the largest managers of such funds in the world, having more than $118 billion in assets under management. Jeremy Grantham (Trades, Portfolio), one of its more vocal founders, is regarded as a highly knowledgeable investor in various stock, bond, and commodity markets, and is particularly noted for his skill of predicting bubbles.
While his team has recorded and tracked dozens of bubbles across the globe, GMO now believes that U.S. equities are up next. Using long-term valuation data (which nearly always reverts to the mean), GMO predicts that most U.S. equity classes will have negative real returns over the next seven years. In fact, even most bonds and international asset classes are expected to have lackluster returns for years to come (see below).
GMO isn’t alone
There are plenty of other long-term valuation metrics that imply that the market is overheated. While it’s typically not used as a near-term indicator, the Shiller P/E is a widely regarded metric to measure the stock market's valuation. The ratio is simply the classic PE ratio, but instead of the past 12 months of earnings, its based on average inflation-adjusted earnings from the previous 10 years. This allows it to be more comparable over long stretches of time.
The current metric stands at over 50% the historical mean of just 16.65. While this doesn’t mean that doom and gloom are just around the corner, no investor can escape the fact that valuation metrics have always returned to their median levels at some point.
Legendary value investor John Hussman (Trades, Portfolio) offered up the following last year:
“Unless we observe a rather swift improvement in market internals and a further, material easing in credit spreads – neither which would relieve the present overvaluation of the market, but both which would defer our immediate concerns about downside risk – the present moment likely represents the best opportunity to reduce exposure to stock market risk that investors are likely to encounter in the coming 8 years.” – John Hussman (Trades, Portfolio)
Don’t assume an average rate of return for the next five to 10 years
Despite optimism, valuations do in fact control long-term returns. The higher the price you pay for a stream of earnings, the lower rate of return you will receive. Even with rosy assumptions, the current multiple on the market just seems too high. To show this example in practice, just ask anyone who was invested in 1928 to 1955, 1936 to 1951, 1964 to 1977, 2000 to 2014, or 2007 to 2014. In all those periods, investors would have made 0% annual returns.
Don’t forget: Annual returns can deviate from average long-term returns for quite some time, sometimes decades.