Valuation Breakevens

Let’s begin by distinguishing the short-run from the full-cycle and the long-run. While we presently observe wicked valuations from a historical perspective, the fact is that valuations often have very little effect on short-term market behavior. The primary factor that drives market fluctuations over short horizons is the preference or aversion of investors toward risk, and the best measure of that is the uniformity or divergence of market internals across a broad range of individual stocks, industries, sectors and security types (when investors are inclined to speculate, they tend to be indiscriminate about it).

While the classification methods we’ve found most reliable in complete market cycles across history remain negative, we follow a broad range of measures, and a few of the less-reliable but still-useful measures are mixed. As a result, our immediate view is currently a bit more neutral than negative. Our overall outlook is defensive either way, so that may seem like a distinction without a difference, but it's mainly a statement about the magnitude of our near-term concerns. Currently, we’d look for more uniform deterioration in market internals before pounding the table about an immediate market collapse.

From a full-cycle perspective, my expectation remains that the S&P 500 is likely to lose between 40-60% of its value over the completion of the current cycle (a market cycle combines a bull market and a bear market, and a full cycle is appropriately measured peak-to-peak or trough-to-trough). On a longer-term perspective, we presently estimate 12-year S&P 500 nominal total returns averaging just 0.6% annually. Indeed, as noted below, unless one believes that the entire structure of the U.S. financial markets has changed since as recently as 2012, investors should allow for the market to lose at least one-third of its value over the completion of the current cycle, with the S&P 500 underperforming even the depressed yields on Treasury bonds over the coming decade.

To get a sense of why these expectations are so pointed, I’ll begin with a familiar chart, which shows the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues). I originated this measure to create a true apples-to-apples metric that also takes foreign revenues into account. Perhaps not surprisingly, we find this measure better correlated with actual subsequent market returns than any other measure we’ve studied, including forward operating P/Es, the Shiller CAPE, price/cash flow, price/dividend, Tobin’s Q, the Fed Model, and market capitalization/GDP, among others. On a 12-year horizon (the point where the autocorrelation profile of valuations typically hits zero, and the most reliable horizon over which mean-reversion can be expected), MarketCap/GVA has a correlation of -0.93 with actual subsequent S&P 500 total returns (negative because higher valuations imply lower subsequent returns).

The chart below presents MarketCap/GVA on an inverted log scale (blue line, left), along with the actual subsequent 12-year nominal annual total return of the S&P 500 Index (red line, right scale).

I occasionally receive questions asking why our valuation measures are supposedly “not working.” Wait. Hold on and look carefully at the chart above. It should be rather obvious that valuations have continued to “work” even in recent complete market cycles, and throughout the recent series of bubbles and crashes, correctly identifying stocks as wickedly overvalued in 2000, today, and to a lesser extent, 2007, while identifying stocks as undervalued in 2009, and reasonably valued in 2002 low. Even the “overshoot” of actual returns from expected returns in the past few years is something that regularly occurs at valuation extremes, particularly when the completion of an extreme cycle occurs a bit sooner or later than usual. Note, for example, the 1988 overshoot of actual market returns for the 12-year horizon that ended with the 2000 peak. The reverse tendency is often seen at major lows. Note, for example, the 1997 undershoot of actual market returns for the 12-year horizon that ended with the 2009 low.