Everything is Awesome? The Dow Crosses 21,000

If you are among the millions of people who own equities outright or in a mutual fund or pension plan, you can be forgiven for singing the song “Everything is Awesome” from the Lego movie. Because for some time now, it truly has been. The bull market in US equities has now lasted about eight years and returned 195% to holders of the S&P 500 Index.

Somewhat surprisingly, the market has continued roaring higher on the hopes of tax reform and regulatory relief. But, investors who choose to commit significant capital to the market at its highs could be in returns far below what they are expecting.

The stock market has oscillated throughout its history between excessive depression and excessive euphoria, which has produced long periods of an upward bias in the stock market and long periods of downward bias. We call the euphoric periods “secular bull markets” and the depressed periods “secular bear markets.” In this case, the word “secular” just means long-term.

Looking at real returns from these distinct market periods very clearly shows this oscillating pattern of collective psychology.


The real return of the S&P 500 throughout different market cycles.

Of course, the challenge from an investor’s perspective is how to predict the turns in these cycles. That is not an easy thing to do, but the best approach is to consider long-term stock valuations. Yale Professor Robert Schiller has devised a method to average the inflation-adjusted earnings of the S&P 500 in an attempt to smooth over short-term distortions in earnings.

Over the very long-term, US equities have traded for an average of 16.7x earnings. Today that ratio is 30.0x earnings, historically an extremely rich valuation. On the other hand, the average ratio for the past twenty years has been 27.0x earnings. How should we make sense of these shifting valuations? What is the appropriate multiple to place on cyclically adjusted earnings?

Stylized facts from previous market inflections.

One factor that must be accounted for is the level of interest rates. Investors always have the option of investing in treasuries as opposed to equities. The higher interest rates are, the lower stock valuations should become to attract investment. Without question, today’s low-interest rate environment is propping up asset valuations.

Taking interest rates into account, equities are actually somewhat cheaper than their twenty-year average and the current risk premium in comparing earnings and treasury yields is a respectable 80 bps. There is one fact that equity investors need to be aware of, though. If bonds are priced to deliver lower future returns and equities are priced relative to bonds, then investors should prepare themselves for lower future returns. How much lower?

The S&P 500 has delivered a nominal total return of about 9.5% and a real return of about 6.5%. With today’s earnings yield only about 55% of its historical average, future returns may only amount to about 5% or so, or perhaps 2%-3% in real terms. That result may prove unsatisfactory, but will still clearly show better returns than US treasuries.

The performance of the economy will also be significantly important to near-term equity performance. The expansion has now lasted about 7 ½ years – quite long by recent standards. The previous three expansions have averaged almost exactly 8 years. If the coming year does bring recession, then the combination of a weaker economy with historically high valuations and rising interest rates could spell doom for equity markets. So, what’s an investor to do?

Clearly, long-term bonds are not a solution. But, it would probably be wise to have sufficient cash reserves that will enable you to act should the market suffer a downturn. And with precious metals pricing still historically low, it is probably not a bad idea to have some exposure to gold along with international equities.


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