My Comments: This post is about investing money for use in the future. The SPX referenced in the title is essentially the S&P 500, basically the 500 largest companies listed on the New York Stock Exchange.
Not long ago, I was the owner of a Registered Investment Advisory firm called Florida Wealth Advisors. Today, many people assume, wrongly, that I have insights into what the stock market will do in the coming months. I want to assure you I have absolutely no clue what to expect in the near term.
In the long term, meaning you probably don’t need to access your investment accounts in the next decade, it really doesn’t matter, since there’s no realistic way to time the market. Just let your account go up and down, knowing it will trend upward over the long term. If you expect to live another 25 – 40 years, there’s no reason to assume markets will not advance as they have in the past.
If, on the other hand, you’re worried about the next 3 years, then I have absolutely no idea how to advise you. Whether these words from Stuart Allsopp will prove to be more or less accurate, I leave it for you to decide.
By Stuart Allsopp \ 23 MAR 2021 \ https://tinyurl.com/yz678aob
At the peak of every market bubble, there is a belief among a majority of participants that, despite all the warning signs from history, this time is different. The main thing that is different this time around is just how wide the gap between the market and the economic outlook has become.
One of the fascinating things about the current market is that unlike previous bubbles which have tended to be largely driven by optimism over the economic outlook, it has actually been supported by the Fed and Treasury’s panicked response to weak economic growth. Not only have the monetary and fiscal policies that many use to justify current valuations been a response to weak growth prospects, they have also actively undermined such prospects by fostering increased leverage and economic distortions. We therefore have a market that is trading at all-time highs and a real economy facing its weakest outlook ever making a crash all but inevitable.
SPX Valuations Stand At 3.6x Historical Averages
As John Hussman noted in his latest excellent article on the stock market bubble, the valuation metrics which are most strongly correlated with future returns show the SPX to be roughly 3.6x historical norms. According to Hussman’s calculations, current valuations are consistent with 12-year total returns of around -4-5%.
These measures are MarketCap/GVA (nonfinancial market capitalization to corporate gross value-added, including our estimate of foreign revenues) and Margin-Adjusted P/E (MAPE). What these valuation metrics attempt to do is capture long-term trends in corporate performance by smoothing out the impact of temporary factors affecting profitability. This gives a truer picture of real equity market valuation compared with traditional valuation metrics as evidenced by the stronger correlations with subsequent returns.
Critics argue that adjusting stock market valuations to account for currently high profit margins is a mistake as these high profit margins are here to stay. However, much of the increase in profit margins seen over recent decades has come from declining interest and tax expenses. As the chart below shows, earnings before tax and interest expenses are no higher than they were at the 2007 peak.
The problem now is that with interest and tax payments at a record low share of corporate profits, there is hardly any room for them to decline. In fact, between the recent action in bond markets, President Biden’s proposed tax hikes, and the surge in commodity prices, margin pressures appear to the downside.
The Growth Outlook Is Much Worse Than Previous Bubbles
Corporate earnings tend to track nominal GDP over the long term, which itself is a function of the growth in the working population and the productivity of their labour. Working-age population growth has turned negative meaning the U.S.’ shrinking workforce is likely to take at least a full percentage point off of long-term growth. In order for real GDP growth to match historical averages then we will need to see an acceleration in productivity growth which has been on a long-term decline and currently sits at around 1%.
The ongoing decline in economic freedom and increasingly short-sighted fiscal and monetary policies strongly suggest that this long-term productivity decline is likely to continue. Even long-sighted policies such as scaling up green energy production will undermine real GDP growth regardless of whether they are worthwhile for climate purposes. I expect real GDP growth to average no higher than 1% over the long term even when measured from the economy’s 2019 peak.
The Combination Of Bubble Valuations And Weak Growth Suggests Major Downside
It is the combination of extreme valuations and weak growth prospects that make future return prospects so weak and the potential for a market crash so high. The -4-5% annual 12-year total return figure implied by Hussman’s valuation metrics are based simply on historical correlations. The idea being that certain valuation measures have tended to result in certain rates of return in the past and we can extrapolate that relationship into the future. However, the growth rates of sales and GDP in the past have been substantially higher than we are likely to see in the future.
We can estimate the kind of returns that SPX investors can expect over the long term if valuations remain at current levels, and then calculate the expected price decline needed for future return prospects to rise to historical averages. This will allow us to get a sense of just how overvalued the market is when weak growth prospects are taken into account.
Hussman’s estimate that valuations are 3.6x historical norms translates into a dividend yield of around 1%. This is arrived at by assuming dividend payout ratios revert back to long-term averages, meaning that the cyclically-adjusted figure is lower than the trailing 1.5%. If we then add on the 1% real GDP growth outlook, we get to a real total return estimate of 2%, which compares with a post-war average of over 7%. In nominal terms, if we add in say 3% for inflation, we arrive at a total return figure of 5% versus a post-war average of 10%. In order for return prospects to rise from 5% to 10% we would therefore need to see the cyclically-adjusted dividend yield rise to 6%, requiring an 83% decline in valuations.
This is not to say that I expect an 83% decline in the SPX. It is possible that profit margins remain elevated longer than expected, or low interest rates mean equity investors will be more content with low returns. Higher inflation may also be able to support nominal returns. However, there is no evidence from history that any of these factors should be expected to prevent a loss of at least 50% over the coming years.
The Inflation Vs. Deflation Debate
At the height of the Covid-driven dollar shortage a year ago I highlighted that a surge in inflation was on the horizon (see ‘Inflation Expectations Are Way Underpriced‘). I still think that over the long term we will see higher inflation rates as prices respond to the combination of huge fiscal deficits and Fed money printing. However, the path from low inflation to high inflation is unlikely to be linear.
As the case for inflation has become clear to more and more investors, they have responded by taking out positions aimed at frontrunning long-term price increases using leverage. Such leverage acts as an inflationary force initially, but creates deflation potential as the borrowing ultimately has to be paid back. This is why even the slightest worries about the Fed’s willingness to keep financial conditions ultra easy can cause large sell-offs across leveraged asset markets. The Fed has painted itself into a corner whereby the more it indicates that it will keep real yields deeply negative, the more investors leverage up on risk assets, and the more the Fed has to prevent real yields from rising to avoid an unwinding of leverage. The promise of easy monetary policy and inflation has therefore raised the deflationary potential inherent in debt. As the chart below shows, NYSE margin debt is at a record high relative to the size of the economy, and even with money supply surging over the past year it remains elevated relative to M2, highlighting the deflationary potential the current bubble holds.