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Thursday, March 28, 2024

Expect Low Returns Over The Next 10-Years

Courtesy of Doug Short.

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.


Dean Baker, in a recent post at the Center For Economic And Policy Research, tries desperately to dismantle an argument over stock valuations and the potential of an asset price bubble. The basis of his argument, that effectively this time is indeed different, utilizes Robert Shiller’s Cyclically Adjusted P/E Ratio and a rather selective bit of data mining. To wit:

“In the last two decades the stock market has twice hit the 25 PE ratio according to Shiller. The first time was in 1997, when Shiller puts the year-end ratio at 27.5. The average real return over the subsequent five years was -0.7 percent. That’s not great, but not exactly a disaster either. Furthermore, the story would look considerably different if we started from the point where the ratio just crossed 25. Shiller puts the 10-year PE at 24.3 at the end of 1996. The average real rate of return for the subsequent five years from that point forward were 8.9 percent. Not much grounds for shedding tears.

The next time the PE crossed the 25 threshold was in 2004 when it hit 27.0. Shiller’s data show the real rate of return in the subsequent five years was 1.1 percent. That’s not fantastic, but it’s probably better than you would have gotten in a money market fund and certainly a hell of a lot better than the negative 12 percent of which Leonhardt warns.

In other words, the last two times the market has crossed this magic 25 PE, investors would have been wrong if they expected a prolonged period of negative real returns. And, since these are the only two times it has crossed this threshold in the last 80 years, we might feel some comfort in using this experience as a basis for expectations of the future.”

In my opinion, this analysis misses some key points.

First, as investors we are supposed to be investing for the “long term.” Mr. Baker’s argument is based on 5 year returns following valuations exceeding 25x earnings. Why not 10 years which would correspond with Shiller’s data? Or 15 years, which is the average amount of time individuals save and invest for retirement?

David Leonhardt recently penned:

“The classic 1934 textbook ‘Security Analysis’ – by Benjamin Graham, a mentor to Warren Buffett, and David Dodd – urged investors to compare stock prices to earnings over ‘not less than five years, preferably seven or ten years.’ Ten years is enough time for the economy to go in and out of recession. It’s enough time for faddish theories about new paradigms to come and go.

Mr. Shiller picked up the Graham-Dodd thread and has long published on his web site a version of the price-earnings ratio that compares current stock prices to average annual earnings over the last decade. He shared the Nobel Prize in economics last year for “empirical analysis of asset prices.”

The chart below shows the long-term history of Shiller’s Cyclically Adjusted P/E Ratio.

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While both David and Dean address valuations exceeding 25x earnings, history shows that valuations above 23x earnings have tended to denote secular bull market peaks. Conversely, cyclical valuations at 7x earnings or less have tended to note secular bull market starting points.

When using a relative comparison, in this case 10-years, what Shiller’s data does provide is a key understanding as to what market returns should be. The chart below compares Shiller’s 10-year CAPE to 10-year forward returns from the S&P 500.

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From current levels history suggest that returns to investors over the next 10-years will likely be lower than higher. We can also prove this mathematically as well as shown.

Capital gains from markets are primarily a function of market capitalization, nominal economic growth plus the dividend yield. Using John Hussman’s formula we can mathematically calculate returns over the next 10-year period as follows:

(1+nominal GDP growth)*(normal market cap to GDP ratio / actual market cap to GDP ratio)^(1/10)-1

Therefore, if we assume that GDP can somehow achieve 4% annualized economic growth, that the current market cap/GDP stays flat at 1.25, and add in the current dividend yield of roughly 2% we get forward returns of:

(1.04)*(.4/1.25)^(1/10)-1+.02 = -5.2%

This is certainly not as encouraging as Mr. Baker suggests.

Secondly, Mr. Baker states:

“In other words, the last two times the market has crossed this magic 25 PE, investors would have been wrong if they expected a prolonged period of negative real returns. And, since these are the only two times it has crossed this threshold in the last 80 years, we might feel some comfort in using this experience as a basis for expectations of the future.”

In the first chart above, I have highlighted the inflation adjusted market price during secular bear market periods as valuations proceeded through a mean reverting process. While Mr. Baker selectively chooses 5-year periods for his analysis, he also ignores the cost to capital caused by inflation. As the highlighted areas show in the chart above, during valuation reversions real returns tend to be stagnant or worse.

What Mr. Baker misses in his analysis is that individual investors who “bought and held” indexed based portfolios since the peak of the bull market in 1999 still suffer a negative rate of return today. More importantly, Mr. Baker’s analysis fails to take into account the loss of the singular most precious commodity to any investor – “time.”

As I stated above, most investors have on average about 15 years to save for their retirement. While an investor can eventually recover lost capital as the markets ebb and flow, they cannot recover the time lost in doing so. As I have stated many times in the past – getting back to “even” is not an investment strategy.

The chart below illustrates these previous two points. It is the inflation adjusted return of a $100,000 investment in the S&P 500 from 1990 to present. The reason that 1990 is important is because that is when roughly 80% of all investors today begin investing. Roughly 80% of those began after 1995. If you don’t believe me, go ask 10 random people when they started investing in the financial markets and you will likely be surprised by what you find.

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Unfortunately, most investors rarely do what is “logical” but react “emotionally” to market swings. When stock prices are rising instead of questioning when to “sell” they lured in near market peaks. The reverse happens as prices fall leading first to “paralysis” and “hope” that losses will soon be recovered. Eventually, near market bottoms the emotional strain is too great and investors “dump” shares at any price to preserve what capital they have left. Despite the media’s commentary that “if an investor had ‘bought’ the bottom of the market…” the reality is that few, if any, actually did. The biggest drag on investor performance over time is allowing “emotions” to dictate investment decisions. This is shown in the 2013 Dalbar Investor Study which showed “psychological factors” accounted for between 45-55% of underperformance. From the study:

“Analysis of investor fund flows compared to market performance further supports the argument that investors are unsuccessful at timing the market. Market upswings rarely coincide with mutual fund inflows while market downturns do not coincide with mutual fund outflows.”

In other words, investors consistently bought the “tops” and sold the “bottoms.” The other two primary reasons of underperformance from the study related to a lack of capital to invest. This is also not surprising given the current economic environment.

Markets are not cheap by any measure. If earnings growth continues to wane or interest rates rise, the bull market thesis will collapse as “expectations” collide with “reality.” This is not a dire prediction of doom and gloom, nor is it a “bearish” forecast. It is just a function of how markets work over time.

[Side Note: It is always assumed that when someone espouses a view that clashes with the current “bull market forever” mantra that they are not invested in the markets. This is very far from the truth as our portfolios are currently fully invested at the current time. However, we have a clear view that while markets can rally sharply from depressed conditions, as we saw in 2009, they also collapse quickly from extended ones like now.]

For investors, understanding potential returns from any given valuation point is crucial when considering they are putting their “savings” at risk. Risk is an important concept as it is a function of “loss”. The more risk that is taken within a portfolio the greater the destruction of capital will be when reversions occur.

This time is “not different.” The only difference will be what triggers the next valuation reversion when it occurs. If the last two bear markets haven’t taught you this by now, I am not sure what will. Maybe three times really is a “charm.”


Originally posted at Lance’s blog: STA Wealth Management

© STA Wealth Management
stawealth.com

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