The stock market serves as a long-term savings vehicle for many investors. This is because it offers a considerably higher potential rate of return than a traditional deposit savings account at a bank. Of course, this added returns potential comes with a considerable cost, which is the risk that the savings dedicated to stocks might decline in value instead of rise. Because of this risk, most people will only put money into stocks that they can afford to keep socked away for many years. So despite the fact that significant attention in the media is focused on daily stock price movements, many investors would be far better served to resist the emotions tied to these daily swings and instead maintain a long-term perspective when evaluating stocks based on past performance and future returns potential. With this broader perspective in mind, while they have certainly performed well over the last few years since the outbreak of the financial crisis, the outlook for U.S. stocks appears most challenging over the coming decade. Thus, it is worthwhile for investors to begin preparing today to not only navigate but also capitalize on what is likely to be a far more opportunistically driven stock market environment in the decade ahead.
An alarming sense of complacency persists among today's stock investors. Following over four years of virtually uninterrupted stock market gains, I suppose such nonchalance should be expected. But just like the calm before the arrival of a major storm, it is often when conditions appear most tranquil in investment markets that all hell is about to break loose.
A few key headwinds are currently threatening the market outlook over the coming decade.
The first is the uncertainty associated with the future direction of monetary policy. Such concerns are warranted, particularly in light of the fact that the Fed has nearly quintupled its balance sheet in recent years in response to the financial crisis and that a majority of its voting members are set to change in the coming months including the Chairman. But despite these risks, many investors remain seemingly unconcerned. For example, I recently heard commentary in the media from a prominent analyst proclaiming that the uncertainty associated the future of monetary policy had now been "baked into the cake" following the recent -5% pullback in stocks. I emphatically disagree with this conclusion, for a mild -5% correction in stocks from the all-time high set in early August to levels that were reached for the first time in history only a few months ago in May can hardly be described as a correction reflecting any meaningful concern. To the contrary, not only has nothing been baked into the stock market cake at this point, the ingredients related to the Fed haven't even been added to the batter. These risks will potentially take months if not years to play out depending on how events unfold with the U.S. Federal Reserve in the coming months.
Another headwind for the market outlook over the coming decade is valuation. Unfortunately, this is a major challenge for stocks that has been years in the making and may take a decade or more to fully unwind. And the fact that stocks are now expensive from a long-term perspective suggest that potential returns over the coming decade are likely to be lackluster at best with the potential for negative annualized returns over extended stretches along the way. In short, those that continue to view any future corrections as short-term buying opportunities as stocks set up to advance to fresh new highs may be gravely disappointed.
Are Stocks Really Overvalued?
The topic of stock valuations is among the most contentious debates on Wall Street today. One could easily invite three analysts into a discussion where one contends stocks are undervalued, another claims they are fairly valued and the third states they are overvalued. As a result, conclusions on stock valuation are subject to wide interpretation. So which perspective is right? It all depends on your time horizon.
Take 1: Forward 12-Month P/E Ratio
Those that contend that stocks are undervalued are often focused on today's prices relative to forward earnings over the coming year. And this approach certainly makes sense on the surface, as investors are paying for what they think something will be worth in the future and not what it was worth in the past. Based on this measure, stocks have looked attractively priced in recent years even despite the strong rally along the way. For example, the 12-month forward P/E ratio on the S&P 500 Index had fallen as low as 12.4x earnings by the time the market bottomed in early 2009, which represented a 22% discount to the long-term historical average of 15.7x over the last century. And it has only been in the last few months with stocks reaching new all-time highs where the forward P/E ratio has finally edged above the long-term historical average. But at 16.0x earnings, valuations are still effectively at fair value, implying the potential for further upside ahead even at current levels.
Determining valuation based on forward earnings over the coming year is problematic for the following reason. It is a measure reliant on forecasts and events that have yet to take place. And if recent history has reminded us of anything, it is that things can play out much differently than anticipated. One has to look no further than the accuracy of recent forecasts tied to the member companies of the S&P 500. It was roughly a year ago that operating earnings for the S&P 500 was projected to come in at $117.75 per share for the 2013 calendar year. Today, this same reading has been revised lower to $108.22 per share. In other words, an investor is receiving -8% less in earnings today than what they were estimated to receive a year ago. And this still assumes that the operating earnings that have been effectively flat since early 2012 suddenly start rising by 3% to 6% each quarter over the second half of the year. If these earnings that have already been subject to steady downward revisions end up coming in closer to the virtually flat trend we have experienced over the past 18 months, the final number for 2013 could end up struggling to cross over $100 per share by the end of the year. This would quickly convert forward stock valuations from a once a reasonable 16.0x earnings to a rather pricey 19.0x earnings just because events played out differently than expected. In short, you often get something very different than what you paid for when buying based on forward earnings.
Take 2: Trailing 12-Month P/E Ratio
Those that contend that stocks are fairly valued if not slightly overvalued tend to focus on today's prices relative to earnings over the past year. Based on this measure, stocks have been attractively priced in recent years, although they are now looking somewhat expensive today. For example, the 12-month trailing P/E ratio on the S&P 500 Index had fallen as low as 13.5x earnings by late 2011 as the improvement of trailing earnings was catching up with the price. This level represented a 15% discount to the long-term historical average of 16.0x over the last century. But in the two years since late 2011, stock prices have risen aggressively while earnings growth has effectively stalled. This has resulted in stocks rising purely on multiple expansion and a 12-month trailing P/E ratio that is now at a 12% premium to its historical average at 18.0x. This is high, but not egregious.
While valuation based on trailing earnings is more reliable than forward earnings, it is also problematic as a valuation tool for the following reason. Certainly, the advantage of trailing earnings over forward is that it is based on events that have already happened, which obviously reduces the uncertainty in the underlying data tied to this approach. However, if you are investing with a long-term horizon lasting over a decade or more, concentrating only on what has taken place over the past year is far too narrowly focused. This is due to the fact that earnings results any given year are influenced heavily by where we currently are in the economic cycle. For while earnings may be depressed when the economy is troughing during a recession, they are also likely to be inflated when the economy is peaking during an expansion. Thus, investors attempting to extrapolate earnings data forward based only on recent earnings data run the risk of outcomes that are vastly different than expectations as the economy shifts along the business cycle. And the risk is particularly high for a disappointing outcome when applying this approach in the fifth year of a virtually uninterrupted stock bull market supported by unprecedentedly aggressive monetary policy.
Take 3: 10-Year Cyclically Adjusted P/E Ratio (CAPE)
Those that contend that stocks are overvalued are often focused on the cyclically adjusted price-to-earnings ratio over the past ten years. Based on this measure, any attractive valuations for stocks were fleeting at the very depths of the crisis in late 2008 and early 2009. For example, the CAPE on the S&P 500 Index edged below its historical average of 16.4x over the last century for a mere seven months from November 2008 to May 2009. And after this brief valuation dip, stocks quickly returned to being vastly overpriced. Today, the CAPE on the S&P 500 stands at 23.0x, which represents a 40% premium to the long-term historical average of 16.4x over the last century.
(click to enlarge)
The 10-Year Cyclically Adjusted P/E Ratio is an advantageous stock valuation metric for several reasons. While it is certainly not a very useful tool for those focused on short-term trading, it is a far more relevant measure for the many market participants that are investing with a long-term time horizon. This is due to the fact that it is a reading that is based on actual historical numbers and also covers a sufficiently long time period that stretches across full business cycles. Thus, it provides a more reasonable measure of what long-term investors should expect over the coming years.
The ability of the CAPE to predict future stock returns also makes it an important measure for long-term investors. Although the CAPE at any given point in time is derived using ten years worth of historical earnings, it has demonstrated an extremely high inverse correlation in predicting annualized stock market returns ten years forward. In other words, the lower the CAPE is today, the higher the returns for stocks over the following ten years. And the higher the CAPE is today, the lower the returns for stocks over the following ten years.
The chart below demonstrates the strength of this relationship. The blue line is the rolling 10-year annualized return on the S&P 500 Index over the past century with the data shown on the right axis. The orange line is the 10-Year CAPE shown on a rolling monthly basis over time with the data shown on the left axis. For the purposes of this analysis the CAPE chart has been inverted and is shown with a ten-year lag. In other words, a data point for any given date is showing what the CAPE reading was ten years before that date.
A CAPE reading at any given point in time has historically provided the strong ability to predict annualized stock market returns over the subsequent ten years. This has been particularly true from the Great Depression up until just before the turn of the new millennium with nearly a one-to-one relationship between the two. Some deviations did exist at the early part of the last century, but this was a time from the 1900s to the 1920s where stocks trailed the potential suggested by their valuation during an environment marked by greater economic volatility, a near market collapse in 1907, the creation of the U.S. Federal Reserve in 1913, World War I in the mid 1910s and a major depression in the early 1920s. But once the Great Depression arrived the relationship has been tightly correlated ever since. That is, of course, until recent years where stocks have vastly exceeded their potential as suggested by the CAPE.
So what exactly changed a few decades ago that suddenly caused long-term stock performance to exceed their valuation potential implied by the CAPE? It was most likely the advent of monetary policy designed to eliminate recessions from the business cycle starting in 1986 and the "Greenspan put" that came the following year in 1987. These two policy strategies alone created a climate where investors were willing to pay higher prices for each dollar of earnings over long-term periods of time bolstered by the confidence that they were exposed to on less risk to the downside thanks to the Fed, which helped to push prices higher. Thus, starting in 1996, which marked a full ten years of these supportive monetary policies being fully in place, we saw 10-year annualized stock returns start to gap higher above the levels implied by the CAPE. And with the Federal Reserve having perpetuated these policies ever since and the "Greenspan put" evolving into the "Bernanke put", this performance gap for stocks above the returns implied by the CAPE has persisted ever since.
The tendency for mean reversion over time does not bode well for stocks going forward. Over the last 27 years, the U.S. Federal Reserve has pursued a course of persistently accommodative monetary policy with a primary stated objective of supporting higher stock prices in order to create a growth supporting "wealth effect". But what do we have to show for these policies over the last three decades. Sure, we skipped the recessions in 1986, 1994, 1998 and 2006 and made the 1990 and 2001-02 recessions very shallow, but at what cost? For it seems that by not allowing the natural cleansing process provided by recessions to take place along the way, sufficient excesses had accumulated in the arteries of the U.S. economy and the global financial system that it nearly had a heart attack by the time we reached 2008. As for the U.S. stock market, it did enjoy a marvelous run higher from 1986 to 2000, but it did so on the back of grossly inflated valuations and has gone essentially nowhere but sideways in the years since including two traumatic bear markets with declines in excess of 50%. And in recent years, the continuation of these policies appears to now be resulting in dramatically widening income disparity, as the wealthiest are reaping the gains of a rising stock market with little pass through effects to the broader economy while the rest are left to cope with declining incomes and persistently high underemployment. This is hardly an ideal outcome from a quarter century of policy and suggests that we may have finally arrived at a point where it is time to try a new approach from a monetary perspective. The fact that President Obama is apparently favoring Larry Summers as the next Chairman of the Federal Reserve over Janet Yellen suggests that such a change in direction may soon be in the offing, as the appointment of Ms. Yellen would be the most logical choice if one were inclined to keep monetary policy on its present course.
A Challenging Decade Ahead
The outlook for stocks over the next decade is deeply challenging. Two scenarios are worth exploring in this regard. The first assumes that monetary policy remains as accommodative for stocks as it has been in the past, which is a big "if" given the magnitude of resources that have already been deployed to this point. The second considers what might happen if the Fed stops worrying so much about the stock market and instead begins pursuing a new monetary policy course focused on other objectives, which is a very likely possibility given the potential for the inventive and sometimes controversial Mr. Summers to soon be taking control of the Fed. In either case, the outlook for stocks over the next decade is muted at best and downright poor at worst.
Suppose the Fed remains steadfast in trying to support persistently rising stock prices. This will become increasingly difficult to accomplish at this stage, as ever more monetary resources are required to achieve the same effect as in the past. In many ways, it is just like blowing up a latex balloon. Initially, it is easy to blow air into the balloon to make it inflate. But once the balloon has reached a certain capacity, it becomes very difficult to blow any more air into it, not to mention the risk of it either popping or having it slip from grip and deflate away. Such is the circumstance the Fed finds itself with monetary policy today. But even if they were to succeed in pumping even more volumes of money into the financial system and are able to maintain this long-term valuation gap for stocks, the returns for the market as implied by the CAPE over the next decade would come in between an annualized +1% and +3% at best. This is not a terrible outcome, but it is hardly exciting given that one can also go out today and purchase a 10-Year U.S. Treasury Note and lock in nearly a +3% yield with a guaranteed principle payment at the end of the term.
Now what if the Fed finally decides to step away from their three decade long policy of supporting higher stock prices at all costs and turns its focus elsewhere. This, of course, is what China (FXI) has been doing over the last few years in working to carry out long-term reforms in an attempt fix the underlying structural problems in their economy, and we see how their stock market has performed along the way. And what if the Fed actually came to the conclusion that allowing a recession to occur (gasp) is actually a good thing for an economy in that it periodically allows some of the pent up excesses to be cleansed from the system and strengthens the economy for the next growth phase. To emphasize, I'm not suggesting that policy makers should allow the economy to collapse, but to simply let it go into recession every few years consistent with its natural cycle over time. What would such a change in policy imply for the U.S. stock market based on the CAPE model?
First, stocks would likely undergo a prolonged corrective phase as the artificially inflating effects of supportive monetary policy on stock prices is unwound. For example, the S&P 500 Index closed on Tuesday at 1639. But if one were to project what the stock market should be trading based on the CAPE model without the support of monetary policy and with all else held equal, the S&P 500 would likely land in the 975 to 1025 range today. This implies that today's stock market is anywhere from +35% to +45% above where it should be trading in a normal environment thanks to the artificially inflating influences of the Federal Reserve. While trading at such lower levels may seem like an outlandish notion given where the S&P 500 is today, it is worth recalling that stocks were trading at or below this range as recently as three years ago.
Second, once this unwind was completed, the subsequent recovery in stocks over the remainder of the decade would likely be muted at best. This is due to the fact that even with a sharp correction in prices, stocks would still be fairly expensive for some time based on its 10-year CAPE. This implies U.S. stocks need to backfill and consolidate for years of overvaluation relative to underlying earnings, resulting in a market that is essentially trading flat on average on a 10-year annualized basis through 2018 and increasing by only 3% on average on a 10-year annualized basis through 2023, all else held equal. In other words, a regression to the mean on the CAPE model without the support of the Fed would effectively have stocks spending the next decade gradually working their way back to current levels in the 1600 to 1700 range on the S&P 500. Once again, while this would not be a catastrophic outcome over the coming decade, it is far less than ideal for those investors accustomed to more robust returns from the U.S. stock market.
It should be noted that this analysis only considers price (the "P" in P/E) and does not take into account the fact that trailing 12-month earnings (the "E" in P/E) on the S&P 500 are running as much as 30% to 40% above their long-term trendline currently at around $60 per share. This reading is likely also inflated today as a result of persistently accommodative monetary policy over the last quarter century. Thus, if one were to factor this point as well into the analysis, it would make the outlook for stocks over the next decade and beyond all the more challenging. Once again, while a $60 per share annual reading on the S&P 500 may seen inconceivable, it should be noted that earnings were at or below these levels as recently as three years ago and less than half of these levels just a decade ago. And with profit margins still lingering near historical highs at a time when a prolonged U.S. credit cycle is likely approaching its end, at least a few dollars being shaved off the 12-month earnings per share number on the S&P 500 is certainly more than possible in the coming years.
So whether the Fed decides to continue applying aggressive stimulus or not, we have arrived at a point in the long-term cycle where future stock returns will be far more difficult to come by over the coming decade than they have been in the past. Such is the price investors will eventually have to pay for stocks being artificially inflated by monetary policy and bringing future price increases forward into the present.
The Elusive Start Of The Next Secular Bull Market
Of course, many investors dismiss the CAPE model as irrelevant, choosing to focus instead on their own valuation measures. But regardless of whatever metric you use, one key fact stands out that should be troubling to the bulls. Whether you base valuations off of forward 12-month earnings, trailing 12-month earnings or the 10-year cyclically adjusted price-to-earnings ratio, none of these measures have come anywhere close to approaching the definitive washout that marked the end of past secular bear markets. In each past instance, valuations fell below their historical averages for an extended period of time culminating in readings that bottomed in the mid to high single digits as a multiple of earnings no matter how you cut them. Unfortunately, we have yet to even scratch the surface in this regard in today's secular bear market that is now going at 13 years and counting.
Perhaps it will be different this time. Perhaps today's secular bear market lasted only 8 years, which is less than half the 17 year historical average length of secular bear markets, and ended with the lows in March 2009. Perhaps it ended not with mid to high single digit valuations but instead with merely a return in prices to the long-term historical average. Perhaps it ended with a generation of investors still able to love stocks instead of hating them the way they did at the end of past secular bear markets. Perhaps it ended without any real pain and without the cleansing of all of the economic and financial dislocations that caused these problems in the first place. Perhaps all of this is true, but if markets have taught us anything over the centuries is that this time is never different.
Strategies For The Challenging Decade Ahead
Just because it looks like the next decade may prove challenging for investors, does not mean this is cause for despair. To the contrary, it provides a backdrop for great opportunity. Investors will almost certainly have to work harder along the way, but such diligence and careful execution has the potential to be handsomely rewarded in the end.
The following are four potential themes that investors may wish to consider as we move out over the coming decade.
1. Stock Selection Should Go Highly Rewarded
Unrewarded stock selection has been one of the most notable characteristics of the recent bull market. This has been primarily due to the fact that broad market indices have been rising relentlessly in recent years driven in large part by lower quality stocks that have less than attractive fundamentals, making the indices hard to beat. But assuming the major market indices are forced to mean revert at some point, particularly if the perpetual support of extraordinarily aggressive monetary policy is finally removed, this should provide investors with the opportunity to separate the wheat from the chaff and capture truly sound long-term investment opportunities at attractive prices along the way. This is among the reasons why previous secular bear markets including most recently the 1970s have been recognized as among the best periods in history for active management and stock selection.
2. It May Finally Be Worth Taking A Walk On The Short Side
The stock market has been brutally unforgiving to any investor that has even considered positioning for a decline in U.S. stock prices in recent years. But if stocks finally enter into an extended corrective phase, particularly if the Fed under new leadership turns their focus toward supporting something other than stock prices, the day may eventually come where it is once again worthwhile to establish short positions not only in U.S. stock categories but also other segments of investment markets where warranted. This may be accomplished either with inverse instruments such as the ProShares Short S&P 500 (SH) or through options strategies. With this being said, any allocations to the short side must be managed carefully and are ideally hedged to protect against the potential for meaningful downside loss.
3. Remember That Investment Opportunities Exist Outside Of U.S. Stocks
The assumption remains for many that the only game in town when it comes to investing is the U.S. stock market. But U.S. stocks are only a small part of a wide and diverse investment landscape that includes all different types of asset classes, many of which are uncorrelated if not negatively correlated with U.S. stocks. Thus, if we are in period where U.S. stocks have entered into a prolonged decline, it is worthwhile to consider what other asset classes may be performing well and offer opportunity along the way. Moreover, while U.S. stocks remain vastly overvalued and have yet to even begin experiencing a full washout, many other categories have already endured major declines and may be much closer to a secular bottom at this stage. While the final trough in these categories may still be a few years away, selected examples including certain European stock sectors such as energy with names like Total (TOT) and Statoil (STO); emerging market debt (EMB) and emerging market stocks (EEM) including major markets such as China ; precious metals such as gold (GLD), gold miners (GDX), silver (SLV), platinum (PPLT) and palladium (PALL); and industrial metals such as nickel (JJN), aluminum (JJU) and copper (JJC) with names like Freeport McMoRan (FCX). Any of these categories may warrant consideration in the future and are likely to do so sooner than U.S. stocks as each are much further along in the cleansing process at this stage of the secular bear market cycle.
4. Cash Is Still King
If we do indeed enter a prolonged challenging period for investment markets, holding a significant portfolio allocation to cash at any given point in time may be considered ideal. This is due to the fact that a near 0% rate of return is a far better outcome than a -30% decline or more in portfolio value. In addition, those standing at the ready with cash are best positioned to pounce once extraordinary investment opportunities present themselves. One has to look no further than Warren Buffett to see how holding a meaningful allocation to cash can work so well over time.
Investment markets may be facing a challenging road ahead in the coming decade. But with challenge comes opportunity. And those investors that are aware of the risks ahead and stand ready to capitalize have the potential to realize outsized rewards in the years ahead even if the broader U.S. stock market finds itself stuck in the mud.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.