Thursday, April 1, 2010

Expensive Markets Revisited

The previous post demonstrated that stock valuations are expensive as measured by Robert Shiller's Cyclically Adjusted PE Ratio. Stock valuations have been this expensive for only 25% of months going back to 1880, and expected returns from these levels are quite low by historical standards. This post will add further evidence to the valuation debate based on some complementary external analysis. In the next post, we will frame the low expected returns to a buy and hold strategy in terms of their impact on retirement income expectations. We will then, mercifully, also offer one potential alternative to a traditional buy and hold strategy that holds a much higher likelihood of retirement success.

More Evidence That Markets are Expensive

It is difficult to take our eyes off the perpetual motion machine that is the current stock market, but when we step back and look at the market in the context of long-term valuations, the conclusions are less exciting. We demonstrated in the previous post that stock valuations are in the top quartile of valuations since 1880, but Societe Generale's Dylan Grice points out in a recent piece that we are, in fact, in the top quintile of valuations, suggesting that stocks are even more expensive than we thought.

Grice concludes:
If only my crystal ball was clearer ... fortunately though, no crystal ball is needed to see that equity markets are expensive. According to Robert Shiller’s latest data, the S&P500 is back in its highest valuation quintile. The risk is there - as it always is - but the returns aren’t. So what do you do? Go take a holiday if you can.[sic]

The chart above shows the 10y real returns which have accrued to investors using each valuation quintile as an entry point. If history is any guide, those investing today can expect a whopping 1.7% annualised return over the next ten years.
Little Hope in Dividends, Either

Prieur de Plessis at Plexus Asset Management shows that markets are also expensive on the basis of dividend yield. The charts and tables below use Shiller's long-term stock market data to break the market's dividend yield down into quintiles and deciles. Note that the market's 10-year normalized dividend yield is currently 2.1%.

The Plexus analysis suggests that, based on the market's normalized dividend yield, investors should expect somewhere between 2.6% and 4.5% annualized real returns going forward from these lofty valuations. Plexus concludes:
Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would not be consistent with the findings to bank on above-average returns based on the current ten-year normalized valuation levels. As a matter of fact, there is a distinct possibility of some negative returns off current price levels.
Wither Profit Margins?

A recent Morgan Stanley piece published by their Australian macro team throws even more cold water on any forward returns enthusiasm you might have retained through the previous analysis. This team analyzed the proportion of aggregate economic productivity that has accrued to corporations' bottom lines over time. The chart below shows that, over the long-term, U.S. corporations have posted earnings representing about 2.5% of U.S. GDP, with a range of 1.5% to 3% during the postwar period.

Since 1994, corporations have been enjoying out-sized profit margins as a share of GDP. Even including the two major earnings baths over the past 10 years, S&P profits have averaged almost 4% of GDP over this period, suggesting corporations, and owners of corporations, have experienced a much larger share of total economic growth than at any other time since WWII. If we assume that corporate profit margins will normalize going forward, one must assume that earnings growth will be less than expected from a forecast of the recent past, even assuming trend economic growth (which I question emphatically).

Expect Lower Returns From Here

If we combine a reversion to the mean in valuations with a reversion to the mean in profit margins, forward expected returns look very gloomy indeed. Morgan Stanley's team concludes that a combination of these factors would model an expected real return to stocks of -7% to -8% over the next decade.

Previous posts on this blog have offered evidence that markets, and the economy, are too complex to enable accurate forecasting. Therefore,we are not attempting to forecast forward economic growth, or what the markets will do over the next few months. Instead, we are using new information with a strong proven correlation to the market's forward returns to adjust the likely range of returns from a buy and hold strategy going forward. A drunk driver may never crash, but the odds of a crash are certainly higher than for a sober driver. In the same way, expensive markets may get more expensive (witness 1994 - 2000), but the odds are long on that outcome.

Fortunately, investors can adopt strategies other than buy and hold that have a much higher probability of delivering strong, consistent returns. We have discussed systematic strategies before, and we will touch on them again in the next post, along with their potential to positively impact investors' lifestyles in retirement.