If you talk to someone who is in their early 40s, they are likely to tell you that they have seen two bull markets and two bear markets in their adult lives. Because their experience has conditioned them to expect that cycle to repeat, many of this vintage will tell you it is time for another bull market. In fact, older investors with much more experience may have a completely different perspective. For someone with 40 or 60 years of market experience, there may be a different possibility considered. Based on the longer time frames, the possibility of a long term bubble may be recognized.
Barry Ritholtz at The Big Picture (here) has a telling graph, courtesy of Ron Griess at The Chart Store.
If this doesn't give you pause to think, then get a reading from the numbness meter. If we were to return to the historical average, GDP would have to rise by 67% with current stock prices or stock prices would have to fall by 40% with current GDP. Here are some examples for stock price decline at constant GDP that would get to the average:
a. 5% average annual decline rate for 6.9 years.
b. 4% average annual decline rate for 8.6 years.
c. 3% average annual decline rate for 11.5 years.
If stock prices remain constant, here are examples of GDP growth that would get to the historical average:
a. 4% average annual growth for 13 years.
b. 3% average annual growth for 17.4 years.
c. 2.5% average annual growth for 20.7 years.
If GDP were to grow at an average annual rate of 2.5% for five years, the stock market return to get to the historical average would be -32.2% total return, or -5.7% average annual return.
If GDP were to grow at an average annual rate of 3% for five years, the stock market return to get to the historical average would be -30.4% total return, or an average annual return of -5.5%.
If GDP were to grow at an average annual rate of 4% for five years, the stock market return to get to the historical average would be -27% total return, or an average annual return of -4.9%.
There will be those who dismiss long term historical relationships between value and stock prices. They do that at their peril. If something is priced above its value it can stay there a long time, but likely not forever. Just as many wise men did not perceive the Japanese bubble, the dot.com bubble and the worldwide credit bubble, there will be wise men who do not see other bubbles.
We are still in a bubble in stocks, now twenty years in duration. This bubble may not deflate to or below historical averages for many more years or it may do so within one or two years or less. Many wise men will be surprised again. Don't be one of them.
