- Current market conditions share numerous similarities with major market peaks of the past, with added headwinds in the form of deteriorating long-term growth prospects and the potential for civil unrest.
- We believe investors should expect little over 2% annual real returns over the long term should valuations remain at current levels.
- For real return prospects to return to the historical average 6% rate we would need to see a market decline of the scale not seen outside the Great Depression.
- Marginally negative rates on cash are unlikely to support stocks when years of dividend income can be wiped out in a matter of minutes.
- We would not be surprised to see investors require the kind of equity risk premiums that prevailed in the 1930s, the last time freedom and prosperity was under threat to the current extent. Such a shift in investor psychology would decimate the SPX.
Current market conditions share uncanny similarities with major market peaks of the past, with the main difference being that the long-term growth outlook is worse and the potential for civil unrest is higher. We cannot rule out a renewed surge in risk appetite keeping stocks elevated for a while longer, but much lower prices lie ahead over the coming months and years as investor psychology shifts from the fear of missing out to the fear of losing capital amid an increasingly perilous economic and political climate. A 50% decline in the SPX would barely begin to restore long-term return prospects to historical averages.
Valuations On Par With The 1929 And 2000 Bubble Peaks
Valuation metrics range from expensive to the most extreme in history depending on which one you look at. The commonly used forward PE ratio shows the SPX is currently trading at over 24x, on par with the 2000 bubble peak. Meanwhile, longer-term valuation metrics such as the cyclically-adjusted P/E ratio show the SPX to be on par with levels seen at the 1929 peak, marginally cheaper than 2000 levels.
Our preferred valuation metric is the payout-adjusted dividend yield. This method adjusts the trailing dividend yield for the fact that dividend payments are currently extremely elevated relative to the long-term trend and nominal GDP. This metric has done a good job of predicting future return prospects in the past. The figure is currently just over 1% which reflects the trailing dividend yield of 1.8% as well as our expectations for dividend payments to decline in the future, something that is already beginning to happen.
The Combination Of Extreme Valuations And Weak Growth Makes For Dire Long-Term Returns
Extreme valuations would still be a concern even if the economic outlook was strong, but it is the combination of extreme valuations and weak growth prospects that suggests long-term returns will be particularly weak. As we argued in ‘NDX: A 75% Crash Should Surprise No One‘ this combination suggests that the long-term prospects for the Nasdaq are as poor as they were back in 2000 despite standard valuation metrics showing current valuations to be less extreme.
Using the same methodology for the SPX suggests that long-term return prospects are far worse than those which prevailed in 2000 and just one third of the post-War average. We believe investors should expect little over 2% annual real returns over the long term should valuations remain at current levels.
The ~2% annual real return prospects for the SPX are unlikely to remain so low but in order for them to rise we would need to see equity prices fall precipitously. In order for real annual return prospects to rise from 2% to 3% we would need to see equity prices fall by 50%. A return to the historical average real return rate of 6% would require an equity market decline the scale of which we have not seen outside the Great Depression.
Risk Appetite Is Breaking Down
The key question is when investor psychology will shift from fear of missing out to fear of losing capital. Our sense is this process is already underway as the majority of stocks continue to underperform the overall market. The chart below from Kailash Capital highlights the weak participation in the recent rally.
The relatively mild drawdown of the market capitalization weighted indices reflects the strong performance of a small number of mega-cap stocks. Even in the glamour stock space though we are seeing a breakdown of risk appetite which threatens to result in an unwind of the gains seen over recent months. Strength in these stocks has built on itself as retail investors in particular have chased them higher by extrapolating rapid growth in their fundamentals. The negative reaction seen today in the shares of Apple, Amazon, Facebook, and Twitter largely reflect the incredible amount of optimism that has already been priced into these stocks.
Don’t Expect Rate Cuts To Help
We have detailed on several occasions how the faith in the ability of easy monetary and fiscal policy to support stocks is wholly unfounded. When the psychology of investors shifts from maximizing gains to minimizing losses, even 0% returns on cash become much more favorable for risky stocks. The primary reason being that losses tend to occur at the worst possible time, when dividend income and employment income is most uncertain. Marginally negative rates on cash are unlikely to support stocks when years of dividend income can be wiped out in a matter of minutes.
Perhaps the best evidence for this is the fact that European stocks trade at far cheaper valuations levels despite lower real interest rates. Even though investors are aware that stocks are likely to return much more than cash or bonds over the long term, they require even greater returns to offset the risk of capital losses at a time of economic uncertainty.
Socio-Economic Tail Risks Are Rising
It is becoming increasingly obvious that the social challenges facing the country are like nothing most Westerners have seen in their lifetimes. The extent to which the woke mob has succeeded in censoring free speech across corporate America and the world has been phenomenal. Free speech has gone from something we take for granted to something that is in its death throes. The gap between those identifying as liberal and those identifying as conservative seems to widen by the day, while decades of progress on race relations is being rapidly undone. It is hard to believe that with the election less than a week away the prospect of a smooth transfer of power is not guaranteed.
Investors do not appear to appreciate the negative impact that these societal trends will have on long-term growth and the tail risks that they pose. We would not be surprised to see investors require the kind of risk premium to invest in stocks that prevailed in the 1930s, the last time freedom and prosperity was under threat to this extent. Such a shift in investor psychology would decimate the SPX.