The current reading of Hussman's MarketCap/GVA (Market Capitalisation to Gross Value Added) model suggests that for the next 12 years, the nominal return for the U.S. stock market stands at an alarming -4% annually. Accounting for inflation, the figure plunges deeper into the red, predicting -8% per annum through 2035. Can a model shine a light on the complex interplay of markets and economies? If so, should this model stay constant over time?
If these predictions were to hold true, they portend an ominous comparison. The worst 12-year real return in the U.S. stock market history was -3.5% per year during the Great Depression, a period spanning from April 1930 to April 1942. This projection implies that future U.S. stock returns could potentially be over two times worse than the bleakest period of American economic history. This begs the question: are we teetering on the edge of an economic abyss akin to the Great Depression, or could the fault lines lie within Hussman's model itself?
Hussman's MarketCap/GVA model isn't my point of contention specifically, rather it lies with valuation models in general. Today, valuation metrics sing a unified refrain—U.S. stocks are overvalued, a harbinger of a significant crash as these metrics gravitate towards their long-term historical averages.
Whether one invokes Hussman's measure, the Buffett indicator, or Shiller's CAPE (cyclically-adjusted price-to-earnings) ratio, the underlying logic remains the same. And therein lies the pitfall — these metrics aren't bound by any deterministic law to return to their long-term averages. Paradoxically, I maintain that valuation multiples are set to remain above their historical norms in the foreseeable future.
The landscape of investing has morphed significantly in the last half-century, with the rise of affordable diversification strategies making investing simpler. Consequently, today's investors are more inclined to accept lower future returns, in effect, higher valuations, than their predecessors, thereby redefining the essence of valuation metrics.
This might seem implausible. To understand, let us take a leap back into the past, to the year 1940. If you were to build a diversified portfolio of U.S. stocks, how would you have accomplished it?
The mutual fund route would appear tempting as it would involve professionals picking stocks for you. Though the concept had taken root in 1924 and had grown through the 1930s, it came with a catch — exorbitant load fees, that could be up to 9% of your total investment.
Suppose you tried to bypass such fees and sought to create a diversified portfolio manually. In that case, it would have necessitated a deep dive into research to decipher the potential winners and losers amongst the stocks. This task would have been further exacerbated by the relatively primitive access to information.
Moreover, this wasn't a one-time affair. It demanded periodic monitoring to decide which stocks to retain and which to offload. It's worth remembering that even today, 50% of public companies cease to exist within a decade.
Further adding to the conundrum was the prevailing economic climate of 1940. The United States was just emerging from the deepest economic crisis in its history. In such a scenario, one might ponder if investing in stocks wasn't merely a gamble. We can comfortably answer that today, thanks to a wealth of historical data. However, back in 1940, the answers were far from clear.
The 'privilege of knowledge' that we enjoy today, the vast troves of information that enable us to make informed decisions, was a luxury absent in 1940. Investing was a high-stakes pastime then, fraught with fees, the emotional turmoil of stock-picking, and the looming question of whether investing in stocks was a worthwhile pursuit.
Now, contrast this with the present-day process of creating a diversified portfolio — open an account, choose an index fund, and voila! The fees have dwindled to almost negligible levels, diversification is included, and there's substantial evidence supporting the strategy.
The simplicity and affordability of investing today, compared to nearly a century ago, raise a pertinent question. How much annual return would you have sacrificed in 1940 for the investment innovations we enjoy today? I'd wager it's at least a few percentage points. As investors collectively gravitate towards this notion, it follows that stock prices would be bid up correspondingly over time.
This phenomenon has been observed over the past few decades. Shiller’s P/E (price-to-earnings) ratio dating back to 1920 reveals an overall increasing trend. The average Shiller P/E ratio was around 15.5 before 2000, and since then it has lingered around 27. This indicates that investors are willing to bid up prices and accept lower returns than their predecessors.
One could argue that this upward shift is wholly attributed to lower interest rates. However, there have been instances in the mid-2000s when interest rates were comparable to today's levels, yet the P/E ratio remained in the mid to high 20s, significantly above the historical average.
If my hypothesis holds water, then valuation metrics are unlikely to revert to their historical averages for any significant duration because modern-day investors would bid them back up if they did. This seems to be the case in the panics of March 2009 and March 2020, but two data point is hardly proof.
Assuming that today's investors are prepared to accept higher valuations implies that they are also willing to accept lower future returns. This is also apparent in the data. When one plots the U.S. stock growth over the next ten years against Shiller's P/E ratio dating back to 1920, a negative correlation emerges. The trend line elucidates that as valuations tend to stretch, U.S. stocks tend to underperform in the future.
The valuation model has inherent flaws. It presupposes that the underlying conditions remain constant across time periods. A P/E ratio of 15 in 1940 doesn't translate to a P/E ratio of 15 in 2009. They may appear the same, but they certainly don't feel the same. It's crucial to bear this in mind the next time alarm bells ring about high valuations. While future returns do seem lower, it's anyone's guess when we will experience them. Until then, embrace investing and take these lessons to heart.
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