Of course, the other side of the inflation was the long unwinding of those bubbles as valuations mean reverted from their previous extremes. As shown below, such reversion led to long periods of low returns for investors.
Another way to look at valuations and forward returns is with a scatterplot. As you will notice, real total returns over the next decade are near zero at current valuations.
While none of this is news, it is a good reminder of where we are currently in the financial cycle. While many hope the bull market of the last decade will continue for another, history suggests such may be a challenge.
“Currently, every measure of valuation suggests investors have thrown all ‘caution to the wind.’”
As noted, valuations are a reflection of investor psychology. As such it is not surprising that investors’ allocations to equities are at record levels.
Investor Allocations & Future Returns
My friend and colleague, Jim Colquitt of Armor ETFs, made a salient point in this regard. The chart below shows the standard deviation between investor allocations and future 10-year returns. Per Jim:“Note that the most recent data point (51.8% as of 12/31/21) is now the highest value in the history of this index. Using this data, I created a regression model to forecast the 10 Year Forward Annualized Price Return for the S&P 500. The result is that from 12/31/21 forward, we should expect a return of -3.85% over the next 10 years for the S&P 500.”
“We can use a scatterplot of the same data. Note the “you are here!” in the bottom right corner and the R-squared value in the top right corner. Such is an extremely tight fit for 70 years’ worth of data.”
Here is the noteworthy takeaway from his analysis.
If history is any guide, current valuations, which reflect investor psychology, suggest that markets get overvalued. As per Jim’s hypothesis, if that is true, we can construct a “fair value” model for markets. To wit: “The chart below plots the actual price of the S&P 500 and the model estimated ‘fair value’ price of the S&P 500. The Z-score gets based on the difference between the actual and model estimates (histogram).”
- The market reverts to, or violates, the model estimate; and/or,
- The Z-score declines to somewhere between -3.0 & -4.0.
This Time Likely Won’t Be Different
As stated at the outset, valuations are a terrible market timing metric. However, they tell us much about asset bubbles, investor psychology, and future returns.No matter how many valuation measures we use, the message remains the same. From current valuation levels, the expected rate of return for investors over the next decade will be low.
A large community of individuals suggest differently as they make a case as to why this “bull market” can continue for years longer. Unfortunately, any measure of valuation does not support that claim.
But let me be clear, I am not suggesting the next “financial crisis” is upon us either. I am simply suggesting that forward returns will be relatively low compared to what was witnessed over the last eight years based on various measures. Such is particularly the case as the Fed, and Central Banks globally, begin to extract themselves from the cycle of interventions.
Notably, this does not mean that markets will only produce single-digit rates of return each year for the next decade. There will be some great years to get invested over that period. Unfortunately, like in the past, the bulk of those years will be spent making up the losses from the coming recession and market correction.
That is the nature of investing in the markets. There will be excellent bull market runs as we have witnessed over the last decade, but for you to experience the up, you will have to deal with the eventual down. It is just part of the full-market cycles that make up every economic and business cycle.
Despite the hopes of many, the cycles of the market, and the economy, have not been repealed. They can be delayed and extended by artificial interventions, but they can not be stalled indefinitely.
No. “This time is not different,” and in the end, many investors will once again get reminded of this simple fact: “The price you pay today for any investment determines the value you will receive tomorrow.”
Unfortunately, those reminders tend to come in the most brutal of manners.
