As Merrill strategist Richard Bernstein noted last week, cash has outperformed stocks for the past 10 years. If this grim reality continues, the abysmal performance will eventually cause investors to lose faith in the “stocks for the long run” religion that developed during the 1990s. The good news is, the longer the crappy run lasts, the better the long-term outlook will be. Major bull markets are usually preceeded by periods of ghastly performance, and they often begin when owning stocks seems unfathomably dumb (e.g., “Death of Equities”).
The bummer about the current situation, though, is that even after a lousy decade, stocks are still expensive. Not on current earnings, where they’re finally at the long-term average of about 15X, but on normalized earnings–adjusted to account for average profit margins–where they’re still modestly above average (though not as grotesquely so as they have been for the last 10 years). Even if you believe that stocks will decline only to their long-term average value before blasting off again, therefore, there’s still likely downside. GMO’s Jeremy Grantham, for one, puts fair value on the S&P 500 at 1100, down another 10% from here, and thinks we’ll get there in 2010.
(It’s worth noting, of course, that the reason 15X normalized earnings is the average is because stocks have spent half the time below that level. Unless the average has permanently changed, stocks will probably spend half their time below 15X in the future, too. So don’t bank on a hard floor at 15X normalized earnings.)
In any event, what does the S&P 500’s current valuation suggest about returns over the next decade? As shown in the chart below, John Hussman calculates that, assuming the usual 6% earnings growth, the S&P is priced to return 3%-6% annually over the next 10 years (-0.5% to 8.5% in extreme scenarios). This is better than the outlook a decade ago, near the peak of the bull market, and assuming we don’t hit a period of horrific inflation, it will probably beat cash. But only just.
John Hussman: Actual S&P 500 trailing 10-year returns in blue. Projected S&P 500 returns for next 10 years at various valuation multiples on normalized earnings (see below) in green, orange, yellow, and red. The returns range from -0.5% to 8.5% (3%-6% on median and average):