Stocks have started trading in the new year of 2014.
Fortunately, they’re not down much. Yet. But one alarming thing about making any negative observation about the stock market these days is that you quickly get heaped with scorn and ridicule. Meanwhile, Wall Street strategists are already one-upping each other in the race to be the most bullish.
The amazing run that stocks have had over the last several years has certainly been exciting and fun for those of us who own stocks.
I own stocks, so I have certainly enjoyed it.
I hope stocks continue to charge higher through 2014, but, unlike most Wall Street strategists, I can’t find much data to suggest that they will. I only have a vague hope that the Fed will continue to pump air into the balloon and corporations will continue to find ways to cut more costs and grow their already record-high profit margins and earnings. And, yes, if the U.S. economy finally starts cranking again, that will likely be a huge help.
But, meanwhile, every valid valuation measure I look at suggests that stocks are at least 40% overvalued.
That doesn’t mean that stocks will crash. But it does strongly suggest that, at best, stocks are likely to produce lousy returns over the next 10 years.
Which valuation measures suggest the stock market is very overvalued?
These, among others:
- Cyclically adjusted price-earnings ratio (current P/E is 25X vs. 15X average).
- Market cap to revenue (current ratio of 1.6 vs. 1.0 average).
- Market cap to GDP (double the pre-1990s norm).
(See charts below.)
How lousy do these measures suggest stock returns will be over the next decade?
About 2% per year for the S&P 500, including dividends — a far cry from the double-digit returns of the past five years and the ~10% long-term average.
If stocks just park at this level for a decade and return 2% a year through dividends, that wouldn’t be particularly traumatic. But stocks rarely “park.” They usually boom and bust. So the farther we get away from average valuations, the more the potential for a bust increases.
So the higher we go, the less surprised I will be to see the stock market crash.
How big a crash could we get?
According to the aforementioned valuation measures, and the work of analysts like John Hussman of the Hussman Funds, 40%-55%.
A 50% crash would take the S&P 500 below 900 and the DOW below 8,000.
Is that going to happen?
I don’t know. But it wouldn’t surprise me.
One thing I do know is that no one else knows, either. We’re all just dealing in probabilities. And, just as importantly, no one knows when. Valuation measures like the ones above are unfortunately not helpful in predicting short- or intermediate-term market moves.
So, maybe the market will continue to move higher through 2014. I certainly would be happy about that. But a careful study of history suggests that a crash is increasingly likely and that long-term stock returns from this level are likely to be crappy.
I’ve explained here why I think the odds of a crash are increasing. And I’ve also explained why, despite this, I’m not selling my stocks. (In short, because I am a long-term investor, I am mentally prepared for a crash, and I am planning to ride out any crash, the same way I did with the 2008-2009 crash. And also because none of the other major asset classes are particularly compelling investments at these prices, either.). I have also argued that everyone who thinks we will all see a “sign” or “catalyst” before a crash should brush up on their history.
In defence of the bulls, there are at least three sophisticated arguments about why the aforementioned valuation measures are wrong — and, therefore, that “it’s different this time.”
- Interest rates are likely to stay near zero for many more years, and in a near-zero rate environment, the fair value for stocks is higher than in a normal rate environment.
- On average, stocks are getting increasingly less risky — and, therefore, old “average” valuation measures don’t apply.
- Changes in accounting rules and aberrant earnings performance during the financial crisis have skewed average long-term valuation measures, making stocks look more expensive than they actually are.
These are all sophisticated arguments, and they merit close consideration.
After considering them, however, I don’t find any of them particularly persuasive. Or, more accurately, I don’t find any of them to be more persuasive than the long-term valuation measures I have cited above.
All of these bullish arguments, moreover, boil down to the following:
“It’s different this time.”
“It’s different this time,” are known as “the four most expensive words in the English language.” Because, too often, when investors and analysts try to justify high prices by arguing that “it’s different this time,” it turns out not to be different, and the investors and analysts end up losing their shirts.
(I know this from experience. Back in 1999, I used a variety of “it’s different this time” arguments to persuade myself and others that the dotcom stocks could continue appreciating. They could have. But they didn’t.)
Of course, you can’t just scoff at those arguing that it’s different this time by saying that it’s never different this time, because sometimes it is.
And that, among other reasons, is why it makes little sense to expend too much energy trying to forecast the market. Because it’s really hard to be right consistently enough to avoid costing yourself serious money.
But making specific forecasts is different from managing your own expectations and being comfortable with a range of possible outcomes.
And my own expectations are that 1) stocks will have lousy returns over the next decade, and 2) the odds of a severe market pullback are steadily increasing.
I will therefore not be surprised to see stocks crash in 2014. And neither should you!
Below are some of the charts that show why I am concerned …
The following three charts show three long-term, time-tested valuation measures, all of which suggest the market is drastically overvalued.
First, from Bill Hester of the Hussman Funds, a recent chart of Professor Robert Shiller’s “CAPE” (cyclically-adjusted PE ratio). The blue line shows the prediction for 10-year returns. The red line shows the actual returns. If you have heard people say, “CAPE doesn’t work anymore,” you might want to read Bill Hester’s analysis. He looks at all the arguments why CAPE doesn’t work and concludes that it does. (We’ll know for sure in 10 years.)
Second, in case you have been convinced that “CAPE” no longer works, here’s a look at price-to-revenue. This measure is calling for a slightly better long-term return for the S&P 500 — just under 5% — but still a far cry from the long-term average.
Third, in case your favourite bulls wave away both earnings and revenue, here’s a chart of market-value-to-GDP. It’s the most pessimistic of the lot. This chart suggests that the S&P 500’s average annual returns for the next 10 years will be negative.
2. A bogus (but popular!) valuation measure.
One thing that people do when stocks get expensive is to find ways to explain why they aren’t expensive. They don’t do this to hoodwink you. They do this because stocks have been expensive for so long that the obvious conclusion must be that they’re not expensive — that it’s different this time.
One measure that people are using right now to argue that stocks are not expensive is the difference between the “earnings yield” and “Treasury yield.” Interest rates are low and earnings are high, so it appears that stocks are delivering far higher “yields” than bonds and are therefore cheap.
The problem with this analysis is that it doesn’t work. Check out this chart below from John Hussman, which “backtests” the analysis. It doesn’t have any predictive power at all.
Over the long haul, stocks track profits. And profits and profit margins are at record highs. Every time previously that profit margins have gotten way above or below average, they have violently reverted to the mean. Many people, including me, think this will happen again this time. The only question is when.
Here’s a long-term look at profit margins. Note how high they are. Note what has happened every time this has been the case in the past.
Byron Wien, a strategist at Blackstone, is worried about profit margins. He also just circulated this chart, which he says suggests that profit margins are “rolling over.” This, he says, is bad news for earnings in 2014.
John Hussman is also worried about profits. He thinks profit margins are so out of whack that corporate earnings will decline at 10% per year for the next four years.
Hussman thinks that two things might cause profits to tank: 1) the decline of government deficits (which have been going directly into corporate coffers), and 2) increasing labour costs, as the labour market gets tighter. Hussman believes that these factors are already causing profits to miss estimates. This, Hussman suggests, may be why there are suddenly way more companies missing profit estimates than beating them:
Market timing is always tough, and I don’t know when profits and the market might break down. That really is anyone’s guess.
John Hussman has posted a fun technical chart addressing this question, though. Technical analysis is generally bunk, and I would never bet a dime on it. But it’s also often fun. And this chart is especially fun.
This chart suggests that the S&P rise off the 2009 bottom has followed a clear “fractal” pattern that is often seen near the end of speculative advances. This chart suggests that the S&P 500 (blue) might hit 1900 before collapsing. (It’s at about 1,820 now).
Anyway, maybe it is indeed “different this time.” So do what you want. But don’t say you weren’t warned!
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