Mesas, Valleys, Plateaus, and Cliffs

In the Navajo Oljato-Monument Valley, along the Utah-Arizona border, a set of mesa formations rises up from the desert. These mesas are defined by high plateaus that tower above the ground, with vertical cliffs defining each side.

In recent decades, we’ve seen the same kind of mesa formations in the equity market; points where historically extreme valuation bubbles temporarily draw S&P 500 10-year returns well above levels that would have been projected on the basis of valuations a decade earlier, with vertical plunges taking returns back to earth as valuations are restored. Modest patterns like that are normal, but at the 2000 valuation extreme, and again today, they have been taken to levels that history will remember as monuments to speculative recklessness.

From the standpoint of market valuations, we know that the autocorrelation profile (the correlation between current valuations and valuations at future dates) tends to hit zero at about 12 years. As a result, reliable valuation measures are typically strongly correlated with actual subsequent market returns over a 12-year horizon, even if they have less impact on market returns during occasional speculative episodes. The chart below illustrates this using the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues), which we find better correlated with actual subsequent S&P 500 total returns than any other indicator. MarketCap/GVA is shown in blue on an inverted log scale. The red line shows actual S&P 500 12-year average annual nominal total returns. Presently, we associate current valuations with prospective S&P 500 12-year returns of roughly zero, coupled with the likelihood of a 50-60% interim market loss.

Recall that interest rates do not affect the arithmetic here. Now, that doesn't mean that interest rates can't affect valuations. Rather, it means that once a given level of valuations is established, interest rates don't change the arithmetic that maps those valuations to expected future market returns. Given any level of valuations, one can estimate prospective market returns from valuations directly, and then those prospective returns can be compared with interest rates if one wishes to do so. See The Most Broadly Overvalued Moment in Market History for more detail on asset pricing; particularly the form, reliability, and magnitude of the relationship between valuations and interest rates.