The Market Sucks, An Expert Speaks

The brilliant commentary of DeForest McDuff. He writes:

The bleak outlook for the U.S. stock market
March 1, 2008

Preview

In this issue, I examine the long-term performance of the U.S. stock market since 1870. Using data made publicly available by Robert Shiller, Yale economist and author of Irrational Exuberance, I identify the major market turning points in history and discuss the outcome of having been invested in each time period.

Except for the peak of the Internet Bubble, today's stock market has the worst overall outlook in the last 60 years. The S&P 500 stock market index has the unfortunate characteristic of being at earnings and price peaks at the same time. In the next 5-10 years, investors can expect single digit returns at best and substantial long-term losses at worst.

Overall, I expect the market to return somewhere between -5% and 5% annually for the next 5-10 years, which is pretty lousy considering that headline inflation is currently 4.3% and rising. And given the real possibility of significant losses, long-term investors would be wise to avoid the U.S. stock market at this time.

All analyses below are my own, but I am heavily influenced by the work of Robert Shiller, John Hussman, and Eric Janszen, as well as a similar piece that I wrote in 2006.

A brief history of the U.S. stock market

The conventional wisdom is that stock market returns have averaged something like 8% over the long-term. From 1885 to 1980, the S&P 500 index returned 8.7% annually including reinvested dividends (returns drop to 6.2% after adjusting for inflation). But what most people don't realize is that the majority of stock market returns occur over segmented 10-20 year time intervals. Adjusting for inflation, it is not uncommon for the stock market to spend decades with near-zero or negative returns.

I calculate long-term returns from 1885 to 1980 because both years correspond to long-term market bottoms. Including the last few decades distort long-term returns because we have not yet completed a full stock market cycle.

The following table identifies the major bull and bear markets in the last 140 years and displays the outcomes of having been invested in each:


The highlighted bull market rows show when investors would do well being in the market. The alternating white rows show the bear markets which have always produced returns less than inflation. Right now, we are in a long-term bear market with no reason to think we are near the end.

I identify the major bull and bear markets by the 10-year lagged price to earnings ratio, that is, today's stock market price divided by the average earnings in the last 10 years. Major market bottoms occur at P/E ratios of 7-12, whereas major market tops occur at P/E ratios well above 20. Today's stock market has a 10-year lagged P/E ratio of 27.5, which is higher than any other time in U.S. history excluding the 1929 and 1999 peaks.

Bear markets typically fall into one of two categories. In the first, the stock market actually declines in dollar value. The only long-term market that the S&P 500 has had a negative dollar return is from 1929-1942, during the Great Depression. In the other bear markets, the stock market return is 0-5% per year, but inflation produces a negative real return. The classic example is the 1970s, where the stock market returned 4.6% over 14 years while inflation averaged 6.8% over the same interval.

In addition, notice the high dividends (5-9%) at stock market lows and low dividends (1-4%) at stock market highs. Today's stock market dividend is a meager 1.2%.

So far, today's bear market resembles the 1970s, and I fully expect it to last another 10 years with little or no real return.

The following chart shows just how overvalued today's stock market is relative to history:


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Adjusted for inflation, the long-term price and earnings growth of the U.S. stock market is around 1.5%, with dividends providing the majority of total returns. Notice the recent divergence of the U.S. stock market relative to corporate earnings and the 100-year price trend. In my view, the stock market is still extremely overvalued, and investors would be wise not to participate at this time.

Long-term earnings growth

The common argument for today's high price-to-earnings multiples is that the Information revolution beginning in the late 90s has dramatically increased U.S. productivity. At least in terms of corporate earnings, this assertion is not supported by the data.

Going all the way back to 1870, corporate earnings adjusted for inflation have increased roughly 1.5% annually (after dividends. The chart below illustrates just how consistent this growth has been over time:


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Although corporate earnings grow steadily over time, stock market prices are much more volatile and cause the long-term peaks and valleys that divide the bull and bear markets. Fundamentally, long-term stock market returns will be determined by the growth rate of corporate profits. But short-term returns will be largely influenced by whether the stock market is cheap or expensive in terms of price:


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Even though stock market prices have declined from their 1999-2000 market peaks, they are still very expensive relative to historical norms. And given how consistent long-run earnings growth has been, there is no reason to think that we are in a new era.

Predicting future returns

Future stock market returns can be estimated by two main components:

Future earnings
Future price-to-earnings multiple
For future earnings, John Hussman points out that corporate earnings have remained steadily within a 6.2% growth channel for the last half-century:


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Click on the image above for a sharper version
Conclusion


Please e-mail thoughts and comments to defomcduff@gmail.com
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