Category Archives: Investing Money

Stocks for the Long Run? Not Now

My Comments: There is increasing uncertainty about the stock market. This uncertainty has been growing now for the past 3 plus years. The long term trends described below, coupled with historically low interest rates, suggest the next decade will be disappointing to most of us.

This analysis comes from a Guggenheim Investors report published last September. I haven’t included all the many charts as you will be better served by going directly to the source to see them. https://goo.gl/UL1SSP

If nothing else, you should read the conclusion below…

September 27, 2017 |by Scott Minerd et al, Guggenheim Investments

Introduction

Valuation is a poor timing tool. After all, markets that are overvalued and become even more overvalued are called bull markets. Over a relatively long time horizon, however, valuation has been an excellent predictor of future performance. Our analysis shows that based on current valuations, U.S. equity investors are likely to be disappointed after the next 10 years. While the equity market could continue to perform in the short run, over the long run better relative value will likely be found in fixed income and non-U.S. equities.

Elevated U.S. Equity Valuations Point to Low Future Returns

U.S. stocks are not cheap. Total U.S. stock market capitalization as a percentage of gross domestic product (market cap to GDP) currently stands at 142 percent. This level is near all-time highs, greater than the 2006–2007 peak and surpassed only by the internet bubble period of 1999–2000. This reading is no outlier: It is consistent with other broad measures of U.S. equity valuation, including Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), Tobin’s Q (the ratio of market value to net worth), and the S&P 500 price to sales ratio.

U.S. Equity Valuation Is Approaching Historic Highs

Here is the bad news for equity investors: At current levels of market cap to GDP, estimated annualized total returns over the next 10 years look dismal at just 0.9 percent (before inflation), based on previous trends. Intuitively this makes sense: Looking back at the history of the time series, it is clear that an excellent entry point into the equity market for a long-term investor would have been a period like the mid-1980s, or in the latter stages of the financial crisis in 2009. Conversely, 1968, 2000, and 2007 would have been good times to get out.

Market Cap to GDP Has Been a Strong Predictor of Future Equity Returns

Market cap to GDP is a useful metric because it has proven to be an accurate predictor of future equity returns. As the chart below shows, market cap to GDP has historically been highly negatively correlated with subsequent S&P 500 total returns, particularly over longer horizons where valuation mean reversion becomes a significant factor. Over 10 years, the correlation is -90 percent.

Market Cap to GDP Has Been a Good Predictor of Equity Returns 10 Years Out

It would be easy to assume that the rise in stock valuations is justified by low rates. A similar argument is made by proponents of the Fed model, which compares the earnings yield of equities to the 10-year Treasury yield as a measure of relative value. While there is some relationship between interest rates and valuation as measured by market cap to GDP, low rates do not explain why equities are so rich. At the current range of interest rates (2–3 percent), we have seen market cap to GDP anywhere from 47 percent to current levels of 142 percent—hardly a convincing relationship. In short, interest rates tell us little about where market cap to GDP, or other valuation metrics, “should” be.

Fixed Income Offers Better Relative Value

For a measure of relative value, we compared expected returns on equities over 10-year time horizons (as implied by the relationship with market cap to GDP) to the expected return on 10-year Treasurys—assuming that the return is equal to the prevailing yield to maturity. Typically, equities would have the higher expected returns than government bonds due to the higher risk premium, but in periods when equity valuations have become too rich, future returns on U.S. stocks have fallen below 10-year Treasury yields. Not surprisingly, past periods where this signal has occurred include the late 1990s internet bubble and 2006–2007.

The chart below demonstrates that if equities over the next 10 years are likely to return just 0.9 percent, 10-year Treasury notes held to maturity—currently yielding about 2.2 percent—start to seem like a viable alternative. The fact that S&P 500 returns over the past 10 years have not been as low as the model predicted can at least be partially explained by extraordinary monetary policy, which may have helped to pull returns forward, but in doing so dragged down future returns.

Conclusion

Based on the historical relationship between market cap to GDP ratios and subsequent 10-year returns, today’s market valuation suggests that the annual return on a broad U.S. equity portfolio over the next 10 years is likely to be very disappointing. As such, investors may want to seek better opportunities elsewhere. Equity valuations are less stretched in other developed and emerging markets, which may present more upside potential.

In fixed income, low yields should not deter investors, as our analysis indicates that U.S. Treasurys should outperform equities over the next decade. But as we explained in The Core Conundrum, low Treasury yields should steer investors away from passively allocating to an aggregate index that overwhelmingly favors low-yielding government-related debt. In particular, sectors not represented in the Bloomberg Barclays Aggregate Index, including highly rated commercial asset-backed securities and collateralized loan obligations, can offer comparable (or higher) yields with less duration risk than similarly rated corporate bonds. We believe active fixed-income management that focuses on the best risk-adjusted opportunities—whether in or out of the benchmark—offers the best solution to meeting investors’ objectives in a low-return world.

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A Stock Market Crash In 2018?

My Comments: Last Monday, I posted comments from three people who said with conviction there was no reason to expect a market correction any time soon.

Today I have someone with no discernable name who says, also with conviction, that we’ll have one next year.

Here’s my take on this: if you are 60 years old or more, prepare for a correction. If you are less than 60 years of age, ignore all this, put your money to work and don’t worry about it.

Now, do you feel better?

November 7, 2017 from GoldSilverWorlds.com

The U.S. stock market is in amazing shape. Every day new all-time highs are set. This must be bullish, and investors should go all-in, right? Well, not that fast, at least not in our opinion. We see many signs that this rally is getting overextended, from an historical perspective. While we clearly said a year ago that we were bullish for this year, we did not see any stock market crash coming (a year ago). Right now, we are now on record with a forecast of a stock market crash in 2018, and it could take place as early as the first weeks / months of 2018.

So far, in all openness and transparency, our warning signals for a mini-stock market crash in November were invalidated. We were horribly wrong in terms of timing. However, we still believe there is a huge risk brewing for a mini-crash. The stronger the current rally, the stronger the fallback.

Yes, we do expect a strong mini-crash in the stock market in 2018, starting early 2018. Central banks will likely step in to avoid a similar chaos as in 2008/2009, so we don’t forecast the end of the financial system.

We do, however, believe a very stiff correction will take place, which potentially could bring a buying opportunity (to be confirmed at that point in time based on intermarket dynamics). More likely, however, we believe that money will rotate out of U.S. stocks into emerging markets. That is why we are very bullish emerging markets in 2018.

The first warning signs of a stock market crash

We published the following warning signs starting in August:
• Is Volatility Making A Higher Low Here?
• Volatility On The Rise As Expected. What’s Next For Stocks?
• Ignore This Series Of Volatility Warning Signs At Your Own Peril
• Volatility Hit Historic Lows This Week. Maximum Complacency Is Bearish!

But the number of concerning indicators is accumulating now. Yes, it may sound as foolish as it can be that right during a strong bull market rally InvestingHaven’s research team talks about concerning indicators. But let’s first deep-dive before you come to a conclusion.

The Dow Jones Industrials chart is one of those concerning charts. The area indicated with “0” shows that the index has risen with more than 30% in 12 months without any meaningful correction. This rally may be amazing, but it is reaching a level never seen before in the past 12 years (including the 2007 rally and major top). All other instances of a 30% rise in 12 months are indicated on this chart (from 1 till 5):
• The 2013 rally (“5”) was as powerful as the current one, but resulted in a mini-crash just 3 months later.
• All other rallies (“1” till “4”) resulted in a strong correction or mini-crash within or right after the 12-month rally.

The current U.S. stock market sentiment shows extreme greed, according to the CNN Money fear & greed index.

In the past 3 years, the Fear & Greed index reached similar levels of bullishness only twice. This bull run is overextended on the short-term time frame for sure.

The stock market breadth, an indicator of strength of market internals, is suggesting that this rally is driven by a minority of stocks. As the broad indexes move higher, there are fewer stocks participating in the rally. Not a good sign.

4 charts suggesting a stock market crash in 2018 based on historical data

Let’s put the current stock bull market in historical context. As the charts speak for themselves, we believe they suggest a stock market crash is brewing, and it could start as early as the first days or weeks of 2018.
The first chart shows the strongest bull markets in the last 80 years. Visibly, the current bull market, which started in 2009, is now close to being the strongest ever. The current strong rally, which comes after an 8-year bull run, is a concerning factor, according to us.

Note from TK: To see these four charts and read the short accompanying text, GO HERE:

How this Bull Market Will End

My Comments: Once again, our assumptions about the future of the current bull market are challenged. I want these writers to be right, and that too is a challenge for me. I share it with you here in hopes it gives you a better idea about what to do with your money.

By Krishna Memani, Brian Levitt & Drew Thornton | August 15, 2017

This secular bull market—the least loved in memory—is now more than 100 months old, and up by 265% from its bottom on March 9, 2009. It is also the second longest bull market on record (after the 1990s’ dot-com boom) and fourth largest in terms of market advance.

For some investors, the sheer age of this cycle is enough to cause consternation. Yet there is nothing magical about the passage of time. As we have said time and again, bull markets do not die of old age. Like people, bull markets ultimately die when the system can no longer fight off maladies. In order for the cycle to end there needs to be a catalyst—either a major policy mistake or a significant economic disruption in one of the world’s major economies. In our view, neither appears to be in the offing:

• Global growth is sufficiently modest. The “accidental” synchronized global expansion (so-called accidental because it was more of a coincidence than a coordinated effort by global policymakers) is already fading, but slowing growth in the United States and China does not foretell a crisis.

• The United States, nine years into this market cycle, has not exhibited the excesses that are indicative of typical economic downturns.

• For its part, China’s high leverage poses a threat to its financial stability, but government actions are likely to be gradual to ensure a phased pace of deleveraging while maintaining growth stability.

• We believe that low inflation globally will provide cover for policymakers to be more accommodative than many expect.

We are optimistic that this cycle will ultimately be the longest on record, though we do not believe our view is Pollyannaish. We will continue looking out for telltale signs indicating the end of the current cycle, even as we believe that none of them are forthcoming:

1. U.S. and/or European inflation increases more rapidly: If inflation picks up meaningfully in the developed world and tighter policy commences, then the cycle will likely be curtailed.

2. High-yield credit spreads widen: The bond market is usually a good indicator of the end of a cycle. Cycles end with the yield curve inverting and high-yield credit spreads blowing out. An equity market sell-off typically follows soon thereafter.

3. The 10-Year U.S. Treasury rate falls and the yield curve flattens: The 10-Year Treasury rate will reflect the real growth and inflation expectations of bond market participants. A flattening yield curve driven by the decline of long-term rates would be an ominous sign for the U.S. and global economy.

4. The U.S. dollar strengthens versus emerging market currencies: A flight of capital from emerging markets to the United States would slow growth among the former—which are major drivers of economic activity—and potentially cause another earnings recession for U.S. multinational companies.

Note: There is a white paper published by Oppenheimer Funds with 18 charts in support of the authors argument that the current bull market will not end soon. You can find it HERE.

One Of The Most Overbought Markets In History

My Comments: As someone with presumed knowledge about investing money, my record over these past 24 months has been pathetic. I’ve been defensive, expecting the markets to experience a significant correction “soon”…

I lived through the crash of 1987, the crash in 2000, and then the Great Recession crash in 2008-09. I saw first hand the pain and chaos from seeing one’s hard earned financial reserves decimated almost overnight.

Only the crash hasn’t happened. But every month there are new signals that one is imminent. And still it doesn’t happen.

I’ll leave it to you to decide if what Mr. Bilello says makes any sense. I’m not sure it does.

by Charlie Bilello, October 22, 2017

The Dow is trading at one of its most overbought levels in history. At 87.61, its 14-day RSI is higher than 99.999% of historical readings going back to 1900.

(Note: Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings, and centerline crossovers. RSI can also be used to identify the general trend. TK)

Sell everything?

If only it were that simple. Going back to 1900, the evidence suggests that such extreme overbought conditions (>99th percentile) are actually bullish in the near term, on average.

Come again? In the year following extreme overbought readings, the Dow has actually been higher roughly 70% of the time with an average price return of 14.2%. From 5 days forward through 1-year forward, the average returns and odds of positive returns are higher than any random day. While the 3-year and 5-year forward returns are below average, they are still positive.

Does that mean we’ll continue higher today? No, these are just probabilities, and 30% of the time the Dow is lower looking ahead one year.

What it does mean is that one cannot predict a market decline based solely on extreme overbought conditions. Declines can happen at any point in time and “overbought” is neither a predictor nor a precondition of a bear market to come.

If one is going to predict anything based on extreme overbought conditions (and I would advise against doing so), it would be further gains. I realize that doesn’t conform to the conventional narrative of “overbought = bearish,” but the truth in markets rarely does.

Don’t Screw Up Index Investing By Making These 3 Mistakes

My Comments: First, my thanks to all of you who wished us well during IRMA’s visit to Florida. We came through unscathed. We were without power for a number of days and believe me when I tell you cold showers every day are not much fun. And we are now watching Maria carefully.

Second, there is increasing evidence that active asset management is starting to pull ahead of passive investing, which is the focus of this article, written a year ago by Walter Updegrave. Some of the references may be out of date but not the underlying message.

Passive investing as a strategy is always ok for some of your money. Overlaying it with some tactical steps to add value is the next step, something that can be done effectively without going all in with skills you perhaps don’t have.

Walter Updegrave – August 10, 2016

For consistently competitive returns, index funds and their ETF counterparts are the way to go. If you doubt that, just take a look at this new Vanguard research paper that lays out the case for indexing and check out the latest S&P Dow Jones Indices index vs. active scorecard, which shows that fewer than 20% of large-company stock funds beat the Standard & Poor’s 500 index over the five- and 10-year periods ending Dec. 31. But just buying index funds and ETFs doesn’t guarantee investing success. To do that, you’ll also need to steer clear of these three all-too-common indexing mistakes.

Mistake #1: Assuming all index funds are cheap. Since index funds simply buy the stocks or bonds that make up indexes like the Standard & Poor’s 500 or Barclays U.S. Aggregate bond index rather than spend millions on costly research and manpower to identify which securities might perform best, they’re able to pass those savings along to shareholders in the form of lower annual fees. Lower fees translate to higher returns and more wealth over the long term. That advantage is especially valuable today given the forecasts for lower-than-usual investment returns in the years ahead.

But not all index funds and ETFs are bargains. While many are available at an annual cost of 0.10% or less, others sometimes charge 10 times or more than that amount, according to Morningstar data. For example, one fund, Rydex S&P 500 Class C, levies a whopping 2.31% in annual expenses, prompting this headline on a recent post about the fund on the American Institute For Economic Research’s Daily Economy blog: “Is This the Worst Mutual Fund in the World?”

Before you invest in an index fund or ETF, make it a point to know how much it charges in annual fees, especially if you’re investing through a broker or other financial adviser. Then don’t buy unless its expenses compare favorably to funds or ETFs that track the same benchmark. You can gauge whether you’re overpaying by seeing how the expenses of the fund you’re considering stack up versus the expenses of the index funds and ETFs that made the cut for the Money 50, Money Magazine’s list of the best mutual funds and ETFs.

Mistake #2: Playing the niche index game. The beauty of index investing is that it allows you to easily and inexpensively create a well-balanced portfolio for retirement savings or other money you’re looking to invest. For example, by combining just three funds—a total U.S. stock market index fund, a total international stock index fund and a total U.S. bond market index fund (or their ETF counterparts)—you have the foundation for a broadly diversified portfolio of stocks and bonds that can get you to and through retirement.

But many investors fall into the trap of believing that the more bases they cover, the more diversified and better off they’ll be. And investment firms are all too willing to oblige them by marketing ever more specialized index offerings, allowing investors to invest in indexes that track everything from wind power and cyber security to obesity and organic foods.

Diversity is a good thing, but you don’t want to overdo it. Once you have a diversified portfolio of stocks and bonds, the extra benefit you get from venturing into investments that focus on narrow slices of the market or obscure niches can be minuscule or even disappear, since more arcane investments often carry higher fees. You also run the risk of ending up with an unwieldy and overlapping jumble of holdings that’s difficult to manage. And, let’s face it, a lot of what’s done in the name of broader diversification is really more about riding the latest fad.

In short, the more you stick to tried-and-true index funds that track wide swaths of the market at a low cost and resist the temptation to invest in every new indexing variation some firm churns out, the less likely you’ll end up “di-worse-ifying” rather than diversifying your portfolio.

Mistake #3: Using index funds to gamble rather than invest. When the indexing revolution got underway back in the 1970s, the idea was for investors to track the performance of broad market benchmarks like the Standard & Poor’s 500 index. The rationale was that since it’s so difficult to outperform the market, investors are better off trying to match the market’s return as much as possible.

Today, however, many investors see index funds as vehicles that can help them juice performance by quickly darting in and out of the stock or bond market as a whole or making bets on a sector they believe is poised to soar, be it growth, value, small stocks, energy, technology, whatever. ETFs are especially popular with such investors since, unlike regular index funds, ETFs are priced constantly throughout the day and can be traded the same as stocks.

Problem is, succeeding at this approach requires investors to have the foresight to know where the market or specific sectors are headed. That’s a dubious assumption at best. Consider how investors swarmed into tech and growth stocks at the end of the ’90s dot.com bubble, confident that double- or even triple-digit returns would continue, only to see shares crash and burn. Or, more recently, how pundits were predicting Armageddon for stocks in the wake of the Brexit vote, only to see the market climb to new highs.

Bottom line: Indexing works best when you use low-cost index funds that cover broad segments of the stock and bond markets as building blocks to create a diversified portfolio that matches your tolerance for risk—and that, aside from periodic rebalancing, you’ll stick with through good markets and bad. Remember that, and you’ll be more likely to benefit from all that indexing has to offer.

The World’s Most Deceptive Chart

My Comments: First of all, Happy Labor Day to everyone. I trust you are able to take some time off to spend with family or do something fun to celebrate the end of summer. I’m working very hard these days to complete a project that I call Successful Retirement Secrets (SRS). My plan is to find a way to reach out to the millions of people not yet retired, and share with them secrets I’ve discovered over the years.

These comments from Lance Roberts surfaced a couple of months ago, but they are even more relevant today. He has a lot of charts, some of which I’ve chosen not to include. I have put a link to his article at the end.

If you have money invested and are wondering how all this talk with North Korea might catch up with your retirement, this is good stuff. On the right of this page is where you can schedule a short conversation with me if you are so inclined.

by Lance Roberts | May 7, 2017

I received an email last week which I thought was worth discussing.

“I just found your site and began reading the backlog of posts on the importance of managing risk and avoiding draw downs. However, the following chart would seem to counter that argument. In the long-term, bear markets seem harmless (and relatively small) as this literature would indicate?”


This same chart has been floating around the “inter-web,” in a couple of different forms for the last couple of months. Of course, if you study it at “face value” it certainly would appear that staying invested all the time certainly seems to be the optimal strategy.

The problem is the entire chart is deceptive.

More importantly, for those saving and investing for their retirement, it’s dangerous.

Here is why.

The first problem is the most obvious, and a topic I have addressed many times in past missives, you must worry about corrections.

The problem is you DIED long before ever achieving that 5% annualized long-term return.

Let’s look at this realistically.

The average American faces a real dilemma heading into retirement. Unfortunately, individuals only have a finite investing time horizon until they retire.

Therefore, as opposed to studies discussing “long term investing” without defining what the “long term” actually is – it is “TIME” that we should be focusing on.

Think about it for a moment. Most investors don’t start seriously saving for retirement until they are in their mid-40’s. This is because by the time they graduate college, land a job, get married, have kids and send them off to college, a real push toward saving for retirement is tough to do as incomes, while growing, haven’t reached their peak. This leaves most individuals with just 20 to 25 productive work years before retirement age to achieve investment goals.

This is where the problem is. There are periods in history, where returns over a 20-year period have been close to zero or even negative.”

Like now.

Outside of your personal longevity issue, it’s the “math” that is the primary problem.

The chart uses percentage returns which is extremely deceptive if you don’t examine the issue beyond a cursory glance. Let’s take a look at a quick example.

Let’s assume that an index goes from 1000 to 8000.
• 1000 to 2000 = 100% return
• 1000 to 3000 = 200% return
• 1000 to 4000 = 300% return
• 1000 to 8000 = 700% return

Great, an investor bought the index and generated a 700% return on their money.

See, why worry about a 50% correction in the market when you just gained 700%. Right?

Here is the problem with percentages.

A 50% correction does NOT leave you with a 650% gain.

A 50% correction is a subtraction of 4000 points which reduces your 700% gain to just 300%.

Then the problem now becomes the issue of having to regain those 4000 lost points just to break even.

It’s Not A Nominal Issue

The bull/bear chart first presented above is also a nominal chart, or rather, not adjusted for inflation.

So, I have rebuilt the analysis presented above using inflation-adjusted returns using Dr. Robert Shiller’s monthly data.

The first chart shows the S&P 500 from 1900 to present and I have drawn my measurement lines for the bull and bear market periods.

It’s A “Time” Problem.

If you have discovered the secret to eternal life, then stop reading now.

For the rest of us mere mortals, time matters.

If you are near to, or entering, retirement, there is a strong argument to be made for seriously rethinking the amount of equity risk currently being undertaken in portfolios.

If you are a Millennial, as I pointed out recently, there is also a strong case for accumulating a large amount of cash and waiting for the next great investing opportunity.

Unfortunately, most investors remain woefully behind their promised financial plans. Given current valuations, and the ongoing impact of “emotional decision making,” the outcome is not likely going to improve over the next decade.

For investors, understanding potential returns from any given valuation point is crucial when considering putting their “savings” at risk. Risk is an important concept as it is a function of “loss.” The more risk that is taken within a portfolio, the greater the destruction of capital will be when reversions occur.

Many individuals have been led to believe that investing in the financial markets is their only option for retiring. Unfortunately, they have fallen into the same trap as most pension funds, which is believing market performance will make up for a “savings” shortfall.

However, the real world damage that market declines inflict on investors, and pension funds, hoping to garner annualized 8% returns to make up for the lack of savings is all too real and virtually impossible to recover from. When investors lose money in the market it is possible to regain the lost principal given enough time; however, what can never be recovered is the lost “time” between today and retirement.

Time” is extremely finite and the most precious commodity that investors have.

In the end – yes, market corrections are indeed very bad for your portfolio in the long run. However, before sticking your head in the sand and ignoring market risk based on an article touting “long-term investing always wins,” ask yourself who really benefits?

This time is “not different.”

The only difference will be what triggers the next valuation reversion when it occurs.

If the last two bear markets haven’t taught you this by now, I am not sure what will. Maybe the third time will be the “charm.”

Source: https://seekingalpha.com/article/4052547-worlds-deceptive-chart

U.S. Stock Valuations haven’t been this Extreme since 1929 and 2000

My Comments: I wasn’t here in 1929 but I was here in 2000. If there is such a thing as handwriting on the wall, you should be able to see it. We’d had a great run up and the year 2000 was just around the corner. Everyone was worried that our computers would crash because years were constructed around the last two digits and all of a sudden, both would be ZERO.

As it happened, nothing happened, except the run up suddenly stopped and everyone had to take a deep breath. And quit buying new stuff with all the money we didn’t have anymore since we’d spent it already. And the market crashed.

Aug 22, 2017 by John Coumarianos

“The stock market is now 35% passive and 65% terrified,” says financial adviser and blogger Josh Brown, a.k.a. “The Reformed Broker.” In other words, more investors nowadays are indexing their money and active managers fear for their futures.

Which begs the question, did Brown get it backwards? Should the 35% of stock investments that’s indexed actually be the terrified money? Yes, James Montier and Matt Kadnar of Boston-based asset manager Grantham, Mayo, van Oterloo (GMO) assert in a new paper called “The S&P 500: Just Say No.” The S&P 500 SPX, +0.17% is so expensive, they say, any money tracking the benchmark U.S. stock market index at this point is more speculation than investment.

Here’s how the authors put it: “A decision to allocate to a passive S&P 500 index is to say that you are ignoring what we believe is the most important determinant of long-term returns: valuation. At this point, you are no longer entitled to refer to yourself as an investor. You may call yourself a speculator, but not an investor.

“Going passive eliminates the ability of an active investor to underweight the most egregiously overpriced securities in the index (we obviously prefer a valuation-based approach for stock selection as well). When faced with the third most expensive US equity market of all time, maintaining a normal weight in a passive index seems to us to be a decision that will likely be very costly. Yet despite this, it remains a popular path, with around 30% of all assets in the U.S. equity market in the hands of passive indexers.”

Montier and Kadnar divide stock prices into four components. Since 1970, dividends, earnings growth, profit margins, and P/E multiple changes have contributed 3.4%, 2.3%, 0.50%, and 0.10%, respectively, to the S&P 500’s 6.3% annualized return after inflation.

By contrast, those same inputs have contributed 2.8%, 3.1%, 3.2%, and 3.8% to the index’s stunning 13.6% annualized real returns over the past seven years. In other words, the current rally is being carried by unusually high and persistent profit margins and multiple expansion, or the amount investors are willing to pay for earnings.

For recent returns to persist, profit margins and P/E multiples must continue to expand. That’s unlikely since both of these components are near all-time highs. GMO uses these four components to try to peer into the future by analyzing the historical cycle of profits, and the firm’s forecasts often resemble the signals of Robert Shiller’s “cyclically adjusted PE ratio” or CAPE, which compares current stock prices to the past decade’s worth of real earnings.

Basically, GMO thinks that U.S. stocks over the coming seven years will lose 6% due to P/E multiple contraction, and another 2.8% from margin contraction. While dividend yield and profit gains will contribute 5% to stock returns,, that still amounts to a real total return of -3.9% for the period.

Even assuming the current P/E ratio and profit margins are normal doesn’t allow for the computation of continued robust returns since P/E and margin expansion account for such a large part of recent gains. Basically, this is the third-most expensive U.S. market ever. The only times stock prices have been higher and prospective returns lower were in 1929 and 2000. A different cyclical adjustment that fund manager John Hussman uses shows the current market as the second-most expensive one.

Next, Montier and Kadnar examine stocks from a more bottom-up perspective, using the median stock’s Shiller PE and Price/Sales ratio. It turns out that the median stock’s Price/Sales ratio has never been more expensive since 1970. The median Shiller PE of stocks in the index is not quite as extreme, but still among the highest readings since 1970.

Finally, Montier and Kadnar run a Benjamin Graham-style stock screen based on four criteria: Earnings yield twice the AAA bond yield; dividend yield two-thirds of the AAA bond yield; total debt less than two-thirds of tangible book value, and Shiller PE of less than 16x. They find no U.S. stocks currently meeting those criteria. The authors quote Graham: “When such opportunities have virtually disappeared, past experience indicates that investors should have taken themselves out of the stock market and plunged up to their necks in U.S. Treasury bills.”

Even allowing for the fact that large U.S businesses are exhibiting monopolistic tendencies, and profit margin cycles appear different lately than in the past, Montier and Kadnar argue that stocks still aren’t cheap.
The upshot is that investors should have as little exposure to U.S. stocks as possible. Foreign stocks don’t offer compelling returns either, but they are priced to deliver at least somewhat higher returns than U.S. stocks. That’s especially true for emerging markets stocks.

While investors who seek relative value must venture abroad, those investing on more absolute terms should hold some cash. “When there is nothing to do, do nothing,” advise the authors. Both relative and absolute value investors should remember economist John Maynard Keynes’s remark that they will necessarily seem “eccentric, unconventional, and rash in the eyes of average opinion.”