As we close out the year riding the wave of the Trump rally, let’s pause for a minute, take a deep breath, and put the current lofty level of the U.S. stock market in context to see what it all means for future stock returns and your portfolio.
Indeed the U.S. stock market, as measured by the S&P 500, is up more than 11 percent for calendar 2016 — with about 6.5%, or more than half of this year’s price appreciation, being logged after the U.S. presidential election. When you add the S&P 500 dividend yield to the mix, you get a total return of a bit more than 13% for U.S. stocks. Hooray!
In a world where bank certificates of deposit return next to nothing and the yield on a 10-year U.S. Treasury is hovering around 2.5% — which means locking up your money for 10 years in exchange for 1.25% on your principal paid semiannually for 10 years — 13% is a big, juicy return for U.S. stock investors, who should all join hands and shout: “Thank you, Federal Reserve, Bank of Japan, and European Central Bank!” Read on and I’ll explain what I mean.
But first, let’s address that big question my clients are asking me almost every day: “With the stock market seemingly full of steam and poised to go even higher, should I jump in now?”
I usually respond by using a quote I borrowed from the iconic investor Warren Buffett and that’s: “Price is what you pay and value is what you get.”
What does this mean?
I’ll use two graphs to make my point.
Here’s the first and it’s the one that Warren Buffett says is his favorite indicator of stock market value.
The power of this graph is in its simplicity. That’s because it measures the total market capitalization (or value) of the U.S. stock market as a percentage of U.S. GDP, which is the generally accepted measure of the total output of the U.S. economy.
This graph reports that, during the past four decades, the total-market-capitalization-to-GDP ratio has varied within a very wide range. The lowest point was about 32%, during the deep recession of 1982, while the highest point was approximately 151%, achieved during the tech bubble in 2000.
Simply put, a high-percentage value means the market is highly valued compared to the total output of the U.S. economy. And, on the other hand, a low percentage value reflects an undervalued market based on total economic output.
Using the historical valuations in the graph above, I have divided market valuation into five zones in the following chart:
Based on this chart and on the graph, you can see for yourself that the U.S. stock market is sitting in significantly overvalued territory as measured by the so-called Buffett Indicator. But, on the other hand, we’ve been in this zone for several years and there’s still a significant way to go before hitting the level achieved just before the tech bubble burst in 2000.
Now here’s a second graph that I look at to get a sense of overall stock market valuation. It’s called the Shiller P/E ratio.
Setting aside all the detail, this graph measures the multiple (the “P/E” multiple) that investors are willing to pay for a dollar of corporate earnings. Think of the “P/E” multiple like the price for a gallon of gasoline. Meaning that when gasoline is priced at around $2 a gallon, it’s cheap and at $4, it’s expensive. But a gallon of gas is still a gallon, it’s simply the price that fluctuates.
It’s the same with corporate earnings: A dollar of corporate earnings is always a dollar of earnings but based on market conditions and investors’ view of the future, the price investors are willing to pay for a dollar of corporate earnings fluctuates. When investors can see nothing but good times ahead, they will pay a high ratio, as they did in 2000 before the tech bubble burst and in 2007 before the sub-prime blow up caused the Great Recession.
As you can see for yourself, the Shiller P/E ratio is currently pegged at 28.06 — which is not as high as the levels before the Tech-Wreck in 2000 and the Great Depression of the 1930s — but slightly above the level before the sub-prime debacle.
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The bottom line here is that like the “Buffet Indicator,” the Shiller P/E ratio says stocks are currently very, very expensive.
How did we get to these eye-popping valuation levels?
It’s because the world’s central banks — the Federal Reserve in the U.S., the Bank of Japan and the European Central Bank — have kept interest rates so low for so long that investors now have no choice but to turn to stocks in search of investment returns.
Said simply, the stock market has become “the only game in town” because of the central bankers’ experimental policies. After all, who wants to sit around with their money in a bank certificate of deposit or a U.S. government bond earning next to nothing when the stock market has returned more than 13% so far this year? It’s enough to cause even the most sensible investor to suffer from a severe case of fear of missing out.
What does this all mean for future stock market returns?
To answer this question, I’ll turn to my friends at GMO. GMO is a very highly respected global money manager that has an outstanding track record of delivering superior risk-adjusted returns to its institutional clients.
This chart, published by GMO at the end of November, shows the annualized real returns they expect from various asset classes over the next seven years after adjusting for inflation.
Looking at this chart, we can see that GMO expects U.S. Large Cap stocks (meaning the S&P 500) to return -3% annually over the next seven years. Yes, that means GMO is publicly forecasting — and telling their clients — that average run-of-the-mill U.S. stocks will produce NEGATIVE 3% returns after inflation year in and year out for the next seven years. That’s shocking to me!
What’s more, this chart reports that, according to GMO, the best returns over the period will be in the emerging markets with some hope in the U.S. High Quality area.
Why am I so stunned by their forecast? It’s because this is a blue-chip, well-respected asset manager that has been in business for about 40 years and that currently manages approximately $88 billion for their clients around the globe; not some second-tier firm making an outrageous forecast to secure some media publicity.
What should the everyday investor do in these markets?
Returning to the Warren Buffett quote – “Price is what you pay and value is what you get” – the U.S. stock market is trading at a very high price relative to its value. But, and this is a big “but,” valuation is a terrible timing indicator. Meaning that overvalued markets can stay overvalued for a long time, especially with the force of the world’s central bankers supporting them.
That’s why I am not expecting a market crash but instead a normal correction of 10 to 20 percent sometime soon. This pullback would move the market from significantly overvalued to moderately overvalued and would improve the prospect for future returns in what will be a low-interest-rate environment going forward.
I’m also not as bearish as my friends at GMO. I see an investment scenario where high-quality, best-in-class companies, with global-distribution platforms that can grow in any economic environment can achieve very high P/E multiples and reward their investors with high returns. But you’ll need to be very selective in identifying them because they are rare, and you’ll have to be a bargain shopper and buy them when the price is right.
That’s why, in these overvalued markets, the strategy I recommend is to keep your powder dry and get your shopping list prepared. That way, you’ll be ready to pounce when the inevitable stock downdraft occurs. I expect it to be quick, sharp, and short-lived.
I’ve given you a lot to ponder in this article as we say goodbye to 2016 and enter 2017. Keep an eye out in January for my special report detailing the stocks to own and the one’s to dump as the world adjusts to the new global realities that are President-elect Trump and Brexit.
God bless and cheers to 2017!