U.S. Stock Valuation Update

A reminder that valuations are NOT short-term timing tools. The purpose of monitoring and understanding stock market valuation data is so we can build more accurate financial projections using more realistic assumptions (and therefore make better financial decisions) and to assist with longer-term investment strategy (i.e. 10-12 year time horizons).

In short, folks who are chasing performance higher at current levels by adding more stocks to their portfolios and/or buying low-quality, money-losing companies at extreme prices are either (1) ignorant to market history, or (2) understand the history but are rationalizing today’s dislocations with “this time is different” or, (3) they simply believe they are smart enough to get out in time.

Let’s take a look at the big picture of U.S. stock market valuations that are more excessive than they’ve ever been in history exceeding even the pre-Great Depression peak at the end of the Roaring Twenties and the Dot-Com Bubble Peak.

Image

Why is this important? This metric has about a 90% correlation to actual 12-year returns. The higher the metric the lower the returns over the next 10-12 years.

Below, Michal Stupavsky plotted the price to sales ratio (p/s) of the S&P 500 along with actual subsequent 5-year returns. Notice the p/s ratio is now at 3.0, and far more extreme than ever before, implying about a 30% loss over the next five years.

Image

However, the correlation to five-year returns is only 0.57. If we extend the timeframe out to ten years we get about a 0.89 correlation to actual subsequent returns, which, implied by the current price/sales ratio, is estimated to be about a 40% loss over ten years.

Now, there are many ways for the S&P 500 to produce a 40% loss over ten years. It could simply lose 40% gradually over the full ten years, or the S&P 500 could lose 70% over the first two years then double over the following eight years, for example. That would result in a 40% loss for the full ten-year period.

As nasty as the latter scenario sounds (i.e. 70% loss in two years), that’s actually preferable then a long, slow drawn-out decline lasting a decade because that volatility in the latter scenario creates opportunity for disciplined investors.

Image

Those who don’t understand history are condemned to repeat it. Valuations indicate this is the worst time in history to be overweight U.S. stocks.

We never know what the catalyst will be that sets off the avalanche or when it will happen. It could be anything at any time. All we need to know, however, is that the market is in a fragile state, susceptible to air pockets and to be vigilant about managing risk…especially for folks nearing retirement or recently retired.

Vigilance and discipline will be rewarded.

Disclosures:

Past performance is no guarantee of future results. All investments maintain risk of loss in addition to gain.

Data from third-parties is believed to be reliable but accuracy is not guaranteed. Much of the data used to interpret the markets and forecast returns are often at odds with each other and can result in different conclusions. Many different factors impact prices including factors not mentioned here.

This is NOT investment advice but merely a general commentary. Individualized investment advice cannot be provided until a thorough review of your unique circumstances and financial goals is completed.

Views provided here are current only as of the moment of posting and are subject to change at any time without notification.