The world’s stock markets suddenly look wobbly.
So it seems a good time to remind everyone that, if stocks suddenly crash, say, 30%-50%, it should not come as a surprise.
Because based on valuation measures that have been valid for the past ~130 years, stocks are at least that overvalued.
True, many people believe “it’s different this time” — that the world has changed and that historical valuation measures are no longer meaningful.
Let’s hope so.
Regardless, I have become increasingly worried about the level of stock prices over the last couple of years.
So far, this concern has made me sound like Chicken Little. And, from a personal finance and business perspective, I hope it will continue to do so. (I own stocks, and I’m not selling them. I also run a business, and it’s easier to run a business when everyone is feeling happy and optimistic and rich.)
But my concern has not diminished.
On the contrary, it grows by the day.
I’ve discussed the two big factors causing this concern in detail here. They are: 1) price, and 2) a change in Fed policy from easing to tightening. Today, I’ll just focus on price.
Here’s the bottom line:
Based on reliable historical measures, stocks are now more expensive than at any time in history, with the brief (and very temporary) exceptions of 1929 and 2000.
True, today’s high prices do not mean that stock prices can’t go even higher. They can. And they might. What they do mean is that, at some point, unless it is truly “different this time,” stock prices are likely to come crashing back down. Just as they did after those two historic market peaks.
(I unfortunately know this especially well. Because I was one of the people hoping it was “different this time” in 1999 and 2000. For many years, it did seem different — and stocks just kept going up. But then they crashed all the way back down, erasing three whole years of gains. This was a searing lesson for me, as it was for many other people. It was also a lesson that cost me and others a boatload of money.)
Anyway, here are three charts for you…
First, a look at price-earnings ratios over 130 years. The man who created this chart, Professor Robert Shiller of Yale, uses an unusual but historically predictive method to calculate P/Es, one that attempts to mute the impact of the business cycle. Importantly, this method is consistent over the whole 130 years.
As you can see, today’s P/E, 27X, is higher than any P/E in history except for the ones in 1929 and 2000. And you can also see how quickly and violently those P/Es reverted toward the mean:
Second, a chart from fund manager John Hussman showing the performance predictions for 7 different historically predictive valuation measures, including the “Shiller P/E” shown above. Those who want to remain bullish often attack the Shiller P/E measure, pointing out that it is useless as a timing tool (which it is). Those folks may also want to note that the 6 other measures in the chart below, including Warren Buffett’s favourite measure, same almost exactly the same thing.
Third, a table from the fund management firm GMO showing predictions for the annual returns of various asset classes over the next 7 years.
As you can see, the outlook for all stocks, but especially U.S. stocks, is bleak. Specifically, GMO foresees negative real returns for U.S. stocks for the next 7 years. Even after adding back the firm’s inflation assumption of 2.2% per year, the returns for most stocks are expected to be flat or negative. The lone bright(er) spot is “high quality” stocks — the stocks of companies that have high cash flow and low debt. Those are expected to return only a couple of per cent per year. (Returns for international stocks are expected to be modestly better, but still far below average).
The real bummer for investors, as GMO’s chart also makes clear, is that no other major class offers compelling returns, either. The outlook for bonds and cash is lousy, too. This puts investors in a real predicament. The only asset class forecasted to provide compelling returns over the next 7 years is… timber. And most of us can’t go out and buy trees.
To be crystal clear:
There is only one way that stocks will keep rising from this level and stay permanently above this level. That is if it really is “different this time,” and all the historically valid valuation measures described above are no longer relevant.
It is possible that it is different this time. Some smart people, like Wharton Professor (and mutual fund advisor) Jeremy Siegel, argue that it is indeed different this time. Some of their arguments seem reasonable. And they might be right.
It is does not seem likely, however, that it is different this time. If only because, every time over the past 130 years that smart people have argued that it is different this time (and they always argue that), it has not, in fact, been different.
And that is one thing to keep in mind as you listen to everyone explain why it’s different this time: One of the things everyone does when stocks get this expensive is attempt to explain the high prices (and justify even higher ones) by looking for reasons why it’s different this time.
That’s what most of us did in 1999 and 2000.
For a while, we seemed “right,” and we were heroes because of it.
But then, suddenly, without much warning, we were drastically, violently wrong.
And we — or me, at least — learned that lesson that I referred to above: That it’s almost never “different this time.”