Stock market valuations have risen so much over the course of this now 8.5-year bull market that we're concerned about the implications of today's prices on future returns. This is a normal part of the bull/bear market cycle and dynamic, but it's easy to lose sight of when the bull market music is playing and everyone is happily dancing and enjoying their recent gains.
Unfortunately, it's as iron-clad a law as exists in investing that the price you pay for something today dictates the return you'll get from it tomorrow.
What trips up some investors from understanding or believing this market truism is the fact that the effects are not typically immediate. As we've reminded readers many times recently, high valuations are a poor timing signal in terms of letting us know when the market is likely to turn lower. High prices can stay high for an extended period of time, and can continue to get still higher. But that doesn't diminish the predictive ability of high valuations to tell us what returns over the longer-term are likely to be as a result of today's high prices.
Normally, in the case of the stock market, this price adjustment dynamic includes a painful bear market that readjusts prices for stocks significantly lower.
Checking the charts
It's been a while since we've looked at the current status of some of the more prominent valuation indicators, so we're going to do that today. I'm going to borrow a number of charts from a recent report by Steve Blumenthal of CMG Capital Management Group. You can find the full report here, and I'd add that if you enjoy wading through these types of charts and facts, Steve's On My Radar report has become one of my favorite weekly reads. (And it's free to sign up for as well, so you can't beat the price!)
First up is a simple chart showing future returns based on current P/E ratios (that's price/earnings ratio). Data is from 1926-2014, using monthly median P/Es. I'm including it first to establish the direct relationship between today's prices and tomorrow's returns. Maybe not next month or next year, but extend the period out long enough and the relationship is rock solid. When current P/Es are low (Quintile 1), future returns are high. When current P/Es are high, future returns are low. The market sits solidly in Quintile 5 today.
P/E ratios can be tricky to decipher, which is why I wrote a detailed primer on the different types and what they're good for earlier this year (The Truth About P/E Ratios). That article may be worth a quick read if you find any of this post confusing.
While the table above uses conventional P/Es, another type that we highlighted in that earlier article is the Shiller P/E, which looks back over 10 years of earnings data to smooth out the peaks and valleys somewhat. Unfortunately, the picture doesn't get any better using the Shiller P/E, as the chart below shows. Looking back to 1880, we see that the market's current Shiller P/E (as of 11-10-17) has now surpassed that of 1929's "Black Tuesday" and lags only that of the pre-2000 dot-com bubble.
Next up is a sort of hybrid of the first two charts. This one uses Shiller P/Es, but arranges them in a similar "future 10-yr returns by quintile" format. Again, from our current starting point, the prognosis for the market as a whole is not particularly bright.
This next chart looks at stock ownership as a percentage of household financial assets. The basic idea here is that when most people are already highly invested in stocks, there aren't many potential buyers to push prices higher. The blue line shows the equity percentage (left axis), while the dotted black line shows actual returns over the subsequent 10 years (right axis).
It's a little tricky to read, but basically shows that when investors are as heavily allocated to stocks as they are today, future returns tend to be quite low. By this metric, we're basically sitting right where we were in 2007, immediately prior to the huge 2008 bear market.
There are a number of other charts/metrics in the full report, all telling the same story. I'm going to finish with this one, primarily because of the data in the yellow oval showing how far the market would have to correct to reach various levels. According to Ned Davis Research, the market would have to fall -28.3% to reach fair value.
Of course, markets often overshoot when making dramatic moves, which is why the -50.4% move to get to a level one standard deviation below fair value is sobering. Given that we're more than one standard deviation above fair value at present makes that seem like a not-unreasonable possibility during the next bear market.
As I wrote last week, the point of all this isn't to alarm you or try to convince you to sell stocks. Rather, it's to combat the euphoria that often takes over near market peaks when returns have been rosy and it's difficult to imagine that the future might look different than the recent past.
It's hard to favor conservative strategies like DAA right now, given returns of more aggressive strategies have been higher. But those conservative strategies are absolutely the key to helping us navigate the dangerous bear market that likely lies ahead in the not-too-distant future.
Thankfully, if you have a healthy allocation to risk-sensitive strategies (such as DAA), you don't have to feel like you have to take a lot of pre-emptive action. Keep following the strategies as they're laid out and start keeping a close eye on the overall risk level of your portfolio.