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This will be a short post.? At present the expected 10-year rate of total return on the S&P 500 is around 4.05%/year.? We’re at the 94th percentile now.? The ovals on the graph above are 68% and 95% confidence intervals on what the actual return might be.? Truly, they should be two vertical lines, but this makes it easier to see.? One standard deviation is roughly equal to two percent.
But, at the left hand side of the graph, things get decidedly non-normal.? After the model gets to 2.5% projected returns, presently around 3100 on the S&P 500, returns in the past have been messy.? Of course, those were the periods from 1998-2000 to 2008-2010.? But aside from one stray period starting in 1968, that is the only time we have gotten to valuations like this.
My last piece hinted at this, but I want to make this a little plainer.? For sound effects while reading this, you could get your children or grandchildren to murmur behind you “We know it can’t. We know it can’t.” while you consider whether the market can deliver total returns of 7%/year over the next 10 years.
There are few if any things that remain permanently valid insights of finance.? Anything, even good strategies, can be overdone.? Even stable companies can be overlevered, until they are no longer stable.
In this case, it is buying the dips, buying a value-weighted cross section of the market, and putting your asset allocation on autopilot.? Set it and forget it.? Add in companies always using spare capital to buy back shares, and maxing out debts to fit the liberal edge of your preferred rating profile.
These have been good ideas for the past, but are likely to bite in the future.? Value is undervalued, safety is undervalued, and the US is overvalued.? A happy quiet momentum has brought us here, and for the most part it has been calm, not wild.? Individually prudent actions that have paid off in the past are likely to prove imprudent within three years, particularly if the S&P 500 rises 10-15% more in the next year.
People have bought into the idea that market timing never matters.? I agree with the idea that it usually doesn’t matter, and that it is usually is a fool’s game to time the market.? That changes when the 10-year forward forecast of market returns gets low, say, around 3%/year.
Remember, the market goes down double-speed.? Just because the 10-year returns don’t lose much, doesn’t mean that there might not be better opportunities 3-5 years out, when the market might offer returns of 6%/year or higher.
Also, remember that my data set begins in 1945.? I wish I had the values for the 1920s, because I expect they would be even further to the left, off the current graph, and well below the bottom of it.
This isn’t the most nuts that things can be.? In fact, it is very peaceful and steady — the cumulative effect of many rational decisions based off of what would have worked best in the past, in the short-run.
As a result, I am looking 10 years into the future, and slowly scaling back my risks as a result.? If the market moves higher, that will pick up speed.
When you decide that “scaling back risks” needs to pick up momentum, what are you going to transition into? Short-Term Treasury, Ultra-Short term treasury, Money markets, Cash, Art, something else? My company is (finally) starting a 401(k), and I am attempting to temper co-workers from getting too aggressive with these inflated asset prices (in my opinion). Seems like a historically terrible time to get in for the first time, but that’s just our luck. So I am trying to recommend something as ballast, as I can see a bloodbath coming in equities that will really sour peoples opinion in our 401(k) and investing in general. Where do I hide? Currently, I plan on VG Short-Term Treasury Index (VSBSX) for my own initial fund selection.
The risks are important for people who have accumulated assets, but much less critical for people just starting to set money aside. If you are just starting a 401k, I suggest figuring out what long-term (20-30 year) asset allocation you want in a “normal” market and set up your account that way. You probably won’t have set aside enough money when this market breaks for it to make a big difference in your long-term returns but it means you won’t have to make any changes in your account in trying to time the bottom. It can be very difficult to actually pull the trigger to shift into a much more aggressive posture when the market has just spent two years crashing – that is when the real money is lost because it is never gained.
Something like a 40/60 to 60/40 equity/bond allocation would allow for rebalancing to occur during the market rise and decline that is likely over the next several years. If retirement is a long way off (15 years+), then a much higher stock allocation would make sense because the pre-crash investment would be small compared to what will be invested during the decline and subsequent rise.
Keep in mind that foreign markets, especially emerging markets, are not as highly valued so a diversified portfolio with value US stocks, developed country equities, and emerging market equities will probably behave better in a crash than the S&P 500.
Yes, I like short-term highest quality bonds as an alternative to stocks.
I think you have to throw out your model for forecasting returns. Its seems like over-data fitting based on the past 70 years of history. I do not think the past 70 years of history says anything about future returns. Largely it seems to assume low returns because p/e ratios mean revert over time.
I hate saying “this time is different”. But perhaps the post WWII area was “different” from the rest of history and offered unusually high returns to equity. Think about this WWII left large swaths of industry completely destroyed. Anyone with capital should have had numerous high return investments to make because the world was scarce of capital. US manufacturers did not have to compete with any other industrialized nation. They had a ton of high return investment potential projects.
We have had 70 years of global capital deepening. The marginal dollar today should be getting a worse return then what it got 70 years ago.
I guess my point is unless you are predicting WWIII then what is the point of your model?
The dot-com bubble was not WW III. Neither is this. The proportion invested in risk assets is a statement by investors. When it is high, they are wrong. Same for when it is low. This is a reliable aspect of human behavior.
And, it fits with the credit cycle at present. Profits falling, debts rising — read John Lonski at Moody’s. That’s the last phase of the credit cycle. Consumer debt is already high. For corporate debt to go there is the last strong part of the economy to take on too much debt. (Okay, the banks aren’t so bad. Just ignore the repo market.)
It’s always different, but the credit cycle is very dependable. So is the valuation of stock as a whole. I will not be leaving much on the table.
I would argue the credit cycle is over too. Hasn’t QE proven it can solve any credit crisis? They didn’t have that tool in 2008…or didn’t know how to use it. Eventually they did. The sequester was arguably as powerful as a credit cycle bust and we didn’t even feel a minor slowdown because QE was doubled. If QE can fill all demand gaps then the credit cycle is basically over.
I would hate to be investing at these prices. But be bearish on stocks here is about the same as being bearish on bonds. PE ratios are not too bad compared to rates.
If you assume PE ratios around here are the new normal (With 10 year rates something between 2.5%-3.5% over the next 30 years) then I would assume equities returns something like 7-9% at these prices. Earnings yield of about 4.5-5% plus economic growth.
Smile when ya say that, pardner. 😉
I could be wrong, but these arguments are the justification for higher pe ratios.
Would you agree if current pe ratios are long-term sustainable that equities are priced to return 7% a year?
1972-1982
Over 25 years from WW II, much of the developed world’s economy had been reconstructed (largely thanks to early help with Marshall Plan etc.), The US was still undeniably the world’s economic and financial powerhouse but was undergoing internal political turmoil and a grinding guerilla war with increasing terrorism. Interest rates were still quite low as they had been since early in the Great Depression and stocks still had fairly high PEs (however you want to measure them). By 1982, inflation and interest rates had spiked to double digits and stock PEs had plunged. Stocks were crushed in 1974 and had negative inflation-adjusted returns from 1972-1982. very few people were predicting all that in 1972.
So I don’t know what path the next 10 years is going to follow and I don’t think the demographics support the potential for either double-digit interest rates or 4% GDP growth in the next 10 years. But I think one thing that doesn’t change much is how long people will wait to see an acceptable return on risk capital. At these levels, the downside is much greater for US stocks than the upside. Just a rise to 3%+ in the 10-year T-bond rate would be strong competition for a likely 10-year return of 3%-5%. History says that stock market declines tend to be violent at these valuations with high debt in the economy creating weak hands. It is likely that every dot to the left of the fitted return of 4% has a 40%+ market crash somewhere in that 10-year period it covers, probably in the first half of that period.
So the scatter on the plot indicates that it is not precisely predictive but there is no reason to believe that history won’t rhyme with the trend. The more people argue that there is no reason the US stock market should decline in the near future, the more it starts to look like 1972, 1999, or 2007.