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The S&P 500 Index closed the quarter at an all-time high. Its valuation has reached the top quintile of its historical valuation range (going back to 1937). Investors and the media are focused on the fact that stocks are attractive due to the unattractive alternatives provided by record low interest rates. This is a mistake and a foolish justification for owning stocks. Investors who are 'reaching for return' by owning stocks, will be in for a rude awakening when the next stock market decline commences.

This is not an article claiming the end of the world is near or a stock market collapse is imminent. The focus of the article is that investors need to be aware that owning stocks at a high valuation is a risky proposition. The future return of stocks is inversely correlated to the market's valuation. Also, the probability of a bear market is directly correlated to the valuation of the stock market. (When the valuation of the stock market is high, the probability of a bear market is high.) Hence, I believe it is highly likely returns from stocks over the next decade are going to be quite low and there is a significant chance the stock market will drop by at least 30 percent before the end of this decade.

Let me lay out my reasoning for this belief. Understanding stock market returns, in the context of history, can be a great lesson for investors. Perhaps the quotes of George Santayana's:

"Those who cannot remember the past are condemned to repeat it."

and Mark Twain's:

"History doesn't repeat itself, but it does rhyme."

underline the importance of understanding stock market history. It is almost indisputable that there is an inverse correlation between long-term (10 years or more) stock market returns and valuation. To illustrate this point, let us look at the historical returns and valuation of the stock market. Below is a valuation chart of the S&P 500 Index since 1937:

(click to enlarge)

Notice how when the stock market has traded close to 20 times earnings, it either moves sideways for awhile or a correction in prices happens. At the end of the first quarter, the S&P 500's cyclically adjusted P/E ratio stood at 17.72. (Note: The cyclically adjusted P/E ratio takes the current price of the S&P 500 Index divided by its peak earnings over the past five years.) This is high by historical standards and is in the top 20 percent of its historical valuation range. Since 1937 the average P/E ratio for the S&P 500 Index is 14. The average annualized return for the stock market is 10.2 percent per year. To illustrate the fact that long-term returns are inversely correlated to stock market valuation, below is a table that breaks out the S&P 500's valuation, based on its month-end P/E ratio, into historical quintiles and subsequent 10-year returns:

(click to enlarge)

The average rate of return when the stock market has sold at a P/E ratio in the top quintile of its valuation range is 5.0 percent per year. This return is much higher than what you can get owning a money market fund or bonds. However, there is substantial risk of owning stocks at this high of a valuation.

To elaborate on this risk, below is a table summarizing the bear markets since 1937. (The analysis looks at points in time, based on month-end prices, where the P/E ratio of the S&P 500 Index peaked. The total return includes dividends and points at which the total return was -20 percent or worse over the subsequent months.)

(click to enlarge)

(click to enlarge)

There have been 10 bear markets (as defined by at least a -20 percent total return) since 1937. All bear markets involve a contraction in the stock market's valuation. The average bear market has started with a P/E ratio of 18.9 - only 6.8 percent higher than today's valuation. The average bear market has ended at an average P/E of 11.2 - 36.9 lower than today's valuation. I believe most investors who are piling into stocks, because of the low levels of interest rates, are not aware of the risks they are taking.

The numbers don't lie. The valuation of the stock market is at a high level and is rich by historical standards. By my estimate, there is about a 75 percent chance we are entering a treacherous period for the stock market. This consists of low returns and a high probability of a bear market. Investors need to be aware of this possibility.

(For investors who want to own stocks, Part II of this article will focus on individual investment ideas that have a higher probability of delivering a return over 5.0 percent and should hold better than the indices if we enter a bear market.)

Source: The Stock Market's Valuation Is Getting Rich - Part I