Friday, July 24, 2015



For the past few years I have been worrying out loud about US stock prices. Specifically, I have suggested that a decline of 40% to 60% would not be a surprise.

I haven't predicted a crash. But I have said clearly that I think stocks will deliver returns that are way below average for the next 10 to 20 years. And I certainly won't be surprised to see stocks crash. So don't say no one warned you!

What my analysis is telling me is:

1) stocks are extremely expensive and will eventually revert toward historical means, probably via a sharp correction of 40% to 60%

2) long-term stock returns from today's level will be about 2% per year — nothing to write home about

I have no idea what the market will do over the near term. But there are two reasons I think long-term stock performance will be lousy:

Stocks are very expensive on almost all historically predictive measures 

The Fed is tightening (or will be soon)

In the past year or two, stocks have moved from being "expensive" to "very expensive." In fact, according to several historically valid measures, stocks are now more expensive than they have been at any time in the past 130 years with the exception of 1929 and 2000 (and we know what happened in those years).

The chart below shows the cyclically adjusted price-earnings ratio of the S&P 500 for the past 130 years. As you can see, today's PE ratio of at least 26 is miles above the long-term average of 15. In fact, it is higher than at any point in the 20th century with the exception of the months that preceded the two biggest stock-market crashes in history. Eventually, the rubber band snaps back. And in the past, without exception, a PE as high as today's has foreshadowed lousy returns for a long time going forward.

Shiller PE with rates

The chart below plots four valuation measures — the Shiller P/E ratio above, another P/E ratio (different calculation), the "Q ratio" (a measure of price to replacement cost), and a regression analysis for stocks themselves. Same message: Averaging the four suggests that stocks are ~80% overvalued.

Stock Market Valuation Indicators

The average:

Stock market valuation (average)

Here's another ratio — one that is fondly referred to as "Warren Buffett's favorite valuation measure." (Because he once said it was.) This one charts the collective value of all stocks to the size of the economy (GDP).  It recently hit its second-highest level ever.

Warren Buffett indicator

Collectively, these charts all say the same thing: Stocks are very expensive.

Every time stocks get this expensive, some people argue that, "it's different this time." This time, they say, stock valuations like today's are justified, and stock prices will just keep going up. Usually, however, it's not different. Eventually, stock prices revert to the mean, usually violently. That's why the words, "it's different this time" are described as the "four most-expensive words in the English language."

Shiller earnings

Bulls often say that Shiller's PE is flawed because it includes the crappy earnings year during the financial crisis. Montier shows in the chart above that, even when you include 2009 earnings (purple), 10-year average corporate earnings (blue) are well above trend (orange). This suggests that, far from overstating how expensive stocks are, Shiller's chart might be understating it.

Montier thinks all the arguments you hear about why today's stock prices are actually cheap are just the same kinds of bogus arguments you always hear in the years leading up to market peaks: seemingly sophisticated attempts to justify more buying by those who have a vested interest in more buying.

Now have a glance below at this recent chart of profits as a percent of the economy. Today's profit margins are the highest in history, by a mile. Note that, in every previous instance in which profit margins have reached extreme levels like today's — high and low — they subsequently reverted to (or beyond) the mean. And when profit margins have reverted, so have stock prices.

profits as a percent of GDP


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