One must distinguish between a boulder resting safely at a permanently high plateau, and a boulder teetering at the edge of a cliff, thanks to temporary and unreliable support. Refrain from imagining that extreme valuations are equivalent to “justified” or “durable” valuations. A century of evidence suggests that something very different is going on.
The summary of our present outlook is this: we view market valuations as obscene, with negative expected S&P 500 total returns over the coming 10-12 year period, and a probable interim loss on the order of -65% over the completion of the current market cycle. Still, in the absence of further deterioration and dispersion in market internals, our immediate market outlook is actually rather neutral. Remember also that a material retreat in valuations, coupled with an early improvement in market internals, is likely to produce favorable investment opportunities far sooner than 10-12 years from now.
Like the 1929 and 2000 market peaks, Wall Street is pushing a great deal of loose analysis intended to “justify” current valuations, imagining that just because prices have reached a certain level, they must actually belong there. Arguments like “valuations are justified given the level of interest rates,” or “given the recent tax cuts,” or “given a growing economy with low inflation” sound reasonable enough, but as we’ve detailed at length in recent months, they don’t hold up to the scrutiny of careful discounted cash flow analysis.
Don’t discount discounted cash flows
A share of stock is ultimately nothing but a claim on a very, very long-term stream of cash flows that will be delivered into the hands of investors over time. Investment, properly defined, is concerned with the price one pays for that very, very long-term stream of future cash flows, and the returns that can be expected as a result of that tradeoff. On this front, the Iron Law is that the higher the price an investor pays for given stream of expected future cash flows, the lower the return the investor can expect over time. Conversely, the lower the price an investor pays for a given stream of expected future cash flows, the higher the return the investor can expect over time.
What we observe at present may be distressing, but we think it’s also accurate. In order for the S&P 500 to be priced for a 10% expected long-term annual return, the Index would presently need to trade at roughly 884; less than one-third of present levels. An 8% expected long-term return would correspond to a level of roughly 1281 on the S&P 500. Indeed, the Index reached this range of prospective returns even by the completion of the most recent market cycle, and the valuation level associated with an 8% expected return exceeds the actual value of the S&P 500 at nearly every point in history except the period surrounding the 1929 peak and the extremes of recent years. The only reason the S&P 500 has posted even 5.2% average annual total returns since the 2000 peak is that the recent extreme has restored the most offensive valuations in U.S. market history. We expect all of that total return to be erased over the completion of this market cycle.
The bottom line is that we fully expect a market retreat on the order of 50-65% over the completion of the current cycle. That’s a different statement than saying that it must occur immediately.
By the completion of this market cycle, there will likely be no talk of the “cost” of getting out too early. The 2000-2002 collapse wiped out the entire total return of the S&P 500 – in excess of T-bill returns – all the way back to May 1996. The 2007-2009 collapse wiped out the entire excess total return of the S&P 500 all the way back to June 1995. We correctly anticipated the extent of both collapses. I can’t emphasize strongly enough how much of our challenges in the recent half-cycle traced to our bearish response to “overvalued, overbought, overbullish” syndromes- which we’ve since subordinated to our measures of market internals, with no exceptions.
Frankly, I expect that the completion of the current cycle will wipe out the entire excess total return of the S&P 500 all the way back to roughly October 1997. That outcome would not even require our most reliable measures of valuation to revisit their historical norms. If you know how our measures of valuation and market action helped us to navigate prior complete market cycles, you know that it would be a mistake to underestimate the full-cycle risks investors currently face, regardless of whether or not those risks are realized immediately.
