Note from Lance: In 2001 when I was at Morgan Stanley I was routinely asked how long before the market would recover. At that point the S&P 500 wasn’t even that far down. My answer left most people thinking I was a bit touched in the head. I said my best guess is it would be 20 years before the market was permanently above it’s 2000 high and it would likely take the Nasdaq until 2035 or so. Adjusted for inflation it would take even longer. Of course it could take less or more time, but the point was that it would likely be a very long time. The S&P 500 didn’t permanently exceed its 1966 peak until the early 1980′s, and it was nowhere near as expensive as the market in 2000. In inflation adjusted terms the market didn’t reach its old level until the early 1990′s. Nor is that unusual in market history. It is in fact the norm as the chart below illustrates. Notice that 1929 was so expensive that after inflation the market didn’t permanently exceed its 1929 high until the early 1980′s!
Disturbingly the market was much more expensive in 2000.
That the biggest bubble in US stock market history would be finished bursting by now would be unusual.
Most of us can relate to driving and having children ask “Are we there yet?” JJ Abodeeley tries to answer that question. Written at the end of last week, JJ sees what we have been going through since 2000 as a long process of the market working itself from an expensive peak to a cheap bottom as well. JJ calls it the value restoration project and looks at how far we have to go realistically. JJ also writes at his blog Value Restoration Project which is a regular read of mine. JJ will be contributing here on an occasional basis going forward. JJ is a Director and Portfolio Manager for Sitka Pacific Capital Management, LLC, a SEC-Registered Investment Advisory firm offering Absolute Return and Global Multi-Asset Class strategies.
The declines in the stock market over the last three weeks have done a lot of damage to most investors’ portfolios. This would merely be an inconvenience if it meant that future returns could be expected to be robust enough to compensate for the losses. In a July 22nd post which coincidentally, was the most recent top in the stock market, I suggested that “the conditions present in the market suggest that the value restoration project in stocks, underway in fits and starts since 2000, will eventually resume.” Investors in the stock market may rightly be viewing this recent decline of about 12% over the last 16 trading days as a painful, but necessary, correction in prices which will once again bring value back to the market. After all, as I wrote in two recent missives, Expensive Markets Mean Low or Negative Prospective Returns and Denominators Matter
The fact is that what you pay matters and expensive markets today mean low or even negative prospective returns going forward. The value restoration project, which began with the peak of the stock market in 2000, is ongoing despite a 2 year cyclical rebound on the heels of unprecedented stimulus.
History however, suggests that market prices broadly will eventually resume declining relative to several denominators, in particular, normalized earnings and gold. Since late 2009, the market’s gain has been of a very different nature– not only have stocks actually declined versus gold and other currencies, but they have been powered by normalized valuations going from expensive (19-20x) to more expensive (23x). This makes the gains over the last year or so particularly vulnerable.
So, in the spirit of Summer driving season and family road trips, the recent market decline begs the question, “Are we there yet”? Unfortunately, checking in with some important valuation indicators suggests the decline of the last several weeks has not accomplished enough to merit a more aggressive long-term portfolio stance.
Normalized P/E Ratio
The Value Restoration Project Resumes
For most of the Spring, the S&P 500 traded between 1300 and 1350 and sported a normalized P/E ratio of around 23x trailing 10 year earnings. At the time, I conducted a historical analysis that found that when the cyclically adjusted P/E ratio is between 22 and 24 the average annual real returns (after inflation) for the subsequent 10 years is -2.2%, the median is-3.1% and the distribution looked like this
With the S&P’s recent decline to 1178, the Cyclically-Adjusted or “Shiller” P/E has decline from a recent high of 23.6 to a somewhat more palatable 20.4. This begs the question of what sort of long-term returns have investors historically seen when the market P/E stood at similar levels as today? There have been 125 monthly occurrences since 1881 when the normalized P/E ratio was between 19 and 21.The average annual real return with dividends reinvested over the subsequent 10 year period is about 1.6%, with roughly 1/3 rd of the 10 year periods resulting in negative returns. While somewhat more encouraging, these are hardly the returns that dreams are made of– or financial planning assumptions, for that matter. For those who prefer to see their probable outcomes expressed in nominal returns, the average is about 4.5%.
A thorough understanding of history suggests that today’s P/E level is still not low enough to warrant a buy and hold or passive approach to U.S. stocks broadly. As Ed Easterling of Crestmont Research is fond of saying, “secular market cycles are not driven by time, but rather they are dependent upon distance—as measured by the decline in P/E to a low enough level to then enable a significant increase.”Considering that the most recent secular market is starting from a spectacularly overvalued normalized P/E of 43.8x in 2000, we have quite a bit farther to travel.
Stocks Priced in Gold
Like a normalized earnings measure, adjusting stock market prices for the effects of a nearly constantly depreciating currency, allows us to assign deeper meaning to price. Please consider my recent post Denominators Matter! What the Price of Gold Tells Us About the Value of Other Assets. The good news is the stocks prices have become even cheaper when adjusted for gold. Amazingly, the nominal price gains since the market low in March of 2009 have now been completely lost, when adjusted for gold. While this is mainly good news for those who own gold, it also gives us insight into the process by which the market is returning to a level where real, long-lasting value can be seen.
Fellow contrarians or disciples of mean reversion may think that this trend is poised to reverse, however a longer-term perspective is in order. We can easily see the secular bull and bear cycles from this chart which shows the Dow Jones Industrials Stock Index adjusted for gold since 1969. The 7x rise in gold since 1999, coupled with the nominal price decline in the Dow or S&P 500, has gone along way towards rectifying the imbalances in the valuation of the two asset classes. However, history suggests that durable, decade long, market bottoms are made at much lower levels.
No, we are not there yet
The recent sell off in the markets have been fast and furious and it would not be surprising to see stocks recover some of the recent losses in the weeks and months ahead. However, as John Hussman wrote in Two One-Way Lanes on the Road to Ruin
It is important to recognize that the S&P 500 is presently only about 13% below its April peak, and the word “only” deserves emphasis…The main problem here is that we essentially have nowhere constructive to goon the upside – advisory sentiment is already overbullish, and despite the recent decline, our 10-year total return projection for the S&P 500 has still only climbed to 5.1% annually. The ensemble of evidence remains steeply negative here.
This evidence most certainly includes the long-term valuation measure discussed here. Investors who take steps to protect their portfolios from the inexorable value restoration project will be in position to benefit from the next real bull market in stocks.