"It's a dangerous business, going out your door. You step onto the road, and if you don't keep your feet, there's no telling where you might be swept off to." -Bilbo Baggins, The Lord of the Rings
There was a very nice piece by John Hussman this week. His commentary dealt largely with stock market valuations and historical bull and bear markets.
In short, peak-to-peak earnings growth throughout all cycles for decades has been about 6%. Powerful secular bull and bear markets are not necessarily driven by earnings growth as is widely believed, but instead by expansion (bull) or contraction (bear) of market valuations. That is, what multiple investors are willing to pay for earnings. The most accurate measure of stock market valuation over the decades has been the Shiller P/E ratio (price to earnings).
As Hussman notes, at the start of secular bull markets, the Shiller P/E has historically been around 7. This was the case in the late 1940's and in the early 1980's. These secular rallies have averaged about 18 years in duration and end with a Shiller P/E over 24. Think about that for a second -- that means in secular bull markets the stock market more than triples due to valuation expansion alone! Investors get more and more confident about the economy and markets and are willing to pay more and more for every dollar of earnings. That is what drives the stock market.
Long, secular bear markets, on the other hand, start with high valuations -- generally with the Shiller P/E over 24 -- and inevitably conclude on average 18 years later with sub-10 Shiller P/E's. Wash, rinse, and repeat. Earnings have been in a growing trend over this whole time, so each stock market peak and valley is generally higher than the last, which accounts for a generally rising stock market in the U.S. over the long haul.
While this is all interesting and important from an investment perspective, my greater point is that market valuation is the key to future performance. Buy when valuations are low (1950's and 1980's) and solid, long-term future returns are almost guaranteed. Buy when valuations are high (late 1990's and early 2000's and 2007), and you are bound to be disappointed by future returns. And that valuation range has spent well over 90% of the time with a Shiller P/E between 7 and 24.
But here's the key. The Shiller P/E, as we sit here and now, is about 24. Yes, the level from which prior secular bear markets have historically started.
So the idea of the here and now being the start of a long-term secular bull market is HIGHLY unlikely. This is certainly no guarantee going forward, but there is a lot of history behind that.
Also, perhaps you should ask yourself whether the economic outlook for the U.S. today is far better than it was in decades past that might render history moot. I hardly think so, but you can formulate your own opinion on that. But even when we had the type of growth in the U.S. like we've had for the past 70 years, when the Shiller P/E reached current levels stocks stagnated for a decade or more.
Something to think about. We'll see if this time is different.
Hussman also had this to say:
The importance of aligning investment strategy with prevailing conditions was nicely summarized by Howard Marks in a letter to investors last week (I've repeatedly quoted Marks in recent weeks, as something of an endorsement of his recent book The Most Important Thing, which is well worth reading):
"One of the things that makes investing interesting is the ever-changing nature of the route to profit, the pitfalls that are present, and the tools and approaches that should be employed. Conscious decisions regarding these things should underlie all efforts to manage capital, and they must be revisited constantly as circumstances and asset prices change. What's right today?
"First, should you prepare for prosperity or not? By prosperity I mean a return to the happy days of the 1980s and '90s, when reported economic growth was strong and consumers were eager to spend. My answer is that we're not likely to see anything like that, in large part because in those decades the gap between stagnant incomes and vigorous consumption growth was bridged through buying on credit. Instead, in the years ahead I think (a) growth in employment and incomes will be sluggish, (b) consumers should be restrained in their borrowing as a result of having experienced the crisis, (c) consumer credit shouldn't be available as readily, and (d) borrowing against home equity will be much less of a factor, especially because home equity is so scarce.
"Second, should you worry more about losing money or about missing opportunities? This one's easy for me. First, the macro uncertainties tell me we won't be seeing a highly effervescent economy or market environment. Second, other people's increasingly aggressive behavior tells me to seek cover. And third, since I don't see many compellingly cheap assets, I doubt there will be gains big enough to make us kick ourselves for having invested too cautiously.
"And that brings me to my third question: what tools should you employ? I think we're back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding... with all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right. (Of course that's not an unfamiliar refrain from me.)
"We can never be sure what will happen – and certainly not when – but it's important to be prepared for what's likely to lie ahead. And understanding the inevitable pendulum swing in the way investments are viewed – from weeds to flowers and back – is an essential ingredient in being able to do so."
Sage advice, if you ask me. Keep your feet, and don't get swept away.
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