Well, it’s official. The stock market has now gotten so far ahead of itself that we’re set up for another decade of crappy returns.
How can we tell?
Because the best predictor of long-term stock returns (emphasis on long-term) is the valuation of stocks at the beginning of the period.
Specifically, when stocks are expensive at the beginning of the period, the long-term returns are likely to be crappy. And when stocks are cheap at the beginning of the period, the long-term returns are likely to be excellent.
A couple of years ago, at the depths of the financial crisis, when the world looked like it was headed to hell in a handbasket (or was already there), stocks were pretty cheap. Returns since then have been excellent.
Now, however, stocks are expensive.
With the S&P nearing 1,300, stocks are trading at a 24X PE, according to professor Robert Shiller’s cyclically-adjusted PE ratio (CAPE). This compares to a long-term average of about 16X. Thus, according to this measure (and several others), stocks are about 50% overvalued.
Photo: Robert Shiller
Robert Shiller’s CAPE, as those of you who read us frequently know, averages 10 years of corporate earnings to smooth out the effects of the business cycle. The reason to “smooth” earnings is to reduce the impact of super-high or super-low profit margins, which can provide a misleading PE ratio.
(When profit margins are super-high, as they are now, the resulting PE on this year’s earnings looks artificially low. And when profit margins are super-low, as they were two years ago, the PE looks artificially high. The CAPE smoothes out this impact to provide a more stable denominator against which to measure stock valuations. See Also: “Here’s The Real Problem For The Stock Market”).
Now, to be clear: PE ratios tell you almost nothing about what stocks will do this year or next year. Over the short-term, valuations can go pretty much anywhere.
(Case in point: Stocks started to be “overvalued” by this measure in the early 1990s, and stayed “overvalued” for the next 15 years.)
But over the long-term stocks do tend to revert to valuation means. And this is why, when stocks are expensive at the beginning of a long-term period (say, 7-years or more), the average returns over that period are likely to be low.
Every quarter, GMO publishes 7-year forecasts for all the major asset classes. These are forecasts for real returns–adjusted for expected inflation of 2.5% a year–so the nominal returns (actual prices) are predicted to be about 2.5% higher than the bars shown here.
But as you can see, the annualized return forecasts for all major classes of stocks (US large-caps, US small-caps, etc.) are predicted to be far below the long-term 6.5% average, and some are predicted to be negative. The forecasts for bonds and cash aren’t much better (for a bigger chart, click the chart):
What looks good in GMO’s view?
Timber (right), which you can’t invest in unless you have $500,000 or more you can sock away for a decade. And “high-quality” US stocks (high cash flow, no debt) and “emerging-markets stocks,” though the returns for both of those are predicted to be lower than average.
Do these forecasts mean a market crash is imminent?
Again, valuation tells you almost nothing about what stocks will do over the short term.
But over the long-term, valuation is a pretty good predictor of long-term returns. And today’s valuations suggest that long-term returns will be… crappy.
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