Funny what a difference two days make.
At the close on Thursday, all we were hearing on CNBC was about how DOW 6,000 was in the bag. Today, with the market up strong for the second day in a row, traders are more optimistic: We just need to see how the market digests Obama’s stimulus package and the Citigroup bailout…and then we’ll know whether this rally is real.
Allow us to make a prediction: Optimism that the rally is “real” will increase every day that the market goes up. And, every day that that happens, you will get more and more worried that you missed the bottom. And then one day, when you just can’t take it anymore, you’ll pull the trigger.
Meanwhile: For long-term investors, stocks are still undervalued–even now. Buy now, and you have a good chance of earning a better-than-average return over the next 10 years. Sure, if the rally isn’t real, you will temporarily lose your shirt. But fund manager John Hussman argues that valuations going into the weekend were as low as they were in late 1931. And the market did pretty well from there.
Below is an update of our 10-year total return projections for the S&P 500 Index (standard methodology ). The heavy line tracks actual 10-year total returns (that line ends a decade ago for obvious reasons). The green, orange, yellow, and red lines represent the projected total returns for the S&P 500 assuming terminal valuation multiples of 20, 14 (average), 11 (median) and 7 times normalized earnings.
I trust that investors no longer shrug off data prior to 1950 as outdated evidence that ignores the “New Economy,” so I’ve included data points back to 1925.
Note that in the Great Depression, valuations did not reach present levels until late-1931. The market would ultimately decline until mid-1932, so in the unlikely event of a second Great Depression, we would experience more weakness still (probably not without a few powerful “bear market rallies” of 20-40% even in that event). Investors should also note that actual total returns in the decade following the 1932 low were reasonable, but on the lower end of expectations because valuations also plunged in the early 1940’s as World War II unfolded. It’s interesting that even an investor who went “all-in” well before the bottom, at triple the level of the ultimate 1932 low, would still have earned positive total returns over the next decade (mid single-digits, outperforming both long-term bonds and Treasury bills).
In overvalued markets, risk-management is generous in the sense that avoiding risk costs very little (or nothing) in terms of foregone long-term returns. In undervalued markets, favourable valuation is generous in that it forgives even the most abominable timing of purchases.
NOW WATCH: Tech Insider videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.