Don't Expect Much from the Market

​I never try to time the market.  However, I do try to value the market.  Predicting the timing and the magnitude of the next correction is nearly impossible, but understanding the current valuation is an exercise we can all do with the goal of estimating long term returns.

If 10-year annual returns are estimated at 5% per year, the long-term investor should not care if that comes 5% per year for 10 years or if it comes from a 25% correction, followed by a 9% return per year.  Either way, you end up in the same place.

When I tell people the market is expensive, the follow up question is usually “do you think we will have a correction? How much? When?”  Unfortunately, I don’t have an answer and anyone who does is probably being paid to have an opinion.  You may have noticed that the best investors admit they have no idea what the market will do in the short run.  I always get a kick out of Buffett when he appears on CNBC.  He is heavily promoted as the greatest investor of all time and the commentators say, “we will get his thoughts on the market and where it is headed”.  Everyone tunes in with anticipation and the first question is “where do you see the market headed this year?”  And Buffett always responds with “Oh, I have no idea”.

People also approach the market as all or nothing.  “Are you in the market or not?”  Great investors are rarely 100% invested or 100% in cash.  The key is to pay attention to your exposure.  When future returns are likely to be high, you are being compensated for the risk you are taking, and exposure should be elevated.  In 2009, I was projecting double digit returns from stocks, so we increased our exposure to 80%.  Today, I’m projecting 2% annual returns over the next 10 years, so our equity exposure is very low in the U.S.  

Here is a framework for projecting future returns:

I find it useful to break down the market returns into the following components:

1)      Real growth (excluding inflation)
2)      Inflation
3)      Dividend Yield
4)      Change in the Price Earnings (P/E) Ratio

1)      Real growth can be broken down further to growth in the labor force and productivity.  Labor force growth is heavily influenced by population growth and demographics.  Developed countries like Europe and Japan tend to have lower growth rates due to an aging population.  Whereas, emerging markets with younger populations have higher growth rates.  The U.S. has an aging population which is expected to slow the growth in the labor force to about 0.3% per year.  It’s very difficult for Government (regardless of party) to have much influence over demographics.  The most significant driver of future growth will come from productivity.  Unfortunately, unlike labor force growth, productivity is very difficult to forecast.  Since WWII, productivity has averaged 2% per year.  Over the past 10 years, it has averaged 1%, and over the past five years, it has averaged 0.6%.  So, let’s be optimistic and assume productivity returns to the long-term average of 2% per year and we also have 0.3% annual growth in the labor force.  This would give us 2.3% annual real growth.

2)      Inflation is fairly straight forward.  Rather than getting fancy with it, I simply use the inflation that is already priced into the bond market.  By not using this estimate, you are assuming you know more than all of the collective market participants around the world that are active in the fixed income markets.  To derive this estimate, you compare the 10-year treasury rate to 10-year TIPS (Treasury Inflation Protected Securities).  Several sources publish these figures real time throughout the day.  Currently, the 10-year treasury yields 2.58% and 10-year TIPs yield 0.52%.  Therefore, annual inflation is projected to be 2.06% over the next 10 years. (2.58% less 0.52%)

3)      Dividend Yield is also straight forward.  The dividend yield on the S&P 500 or “the market” is currently 1.8%.  This is the total dollar value of dividends paid by the largest 500 public companies divided by the total market value of those companies.

4)      Change in P/E Ratio:  If you compare today’s prices to last year’s earnings of the S&P 500, the ratio is 23.6.  If you use the less reliable forward P/E based on next year’s estimated earnings, you get 18.4.  The problem with both measures is that companies go through cycles including recessions and expansions.  Today, companies have record high profit margins which makes the P/E ratios appear more attractive.   In the great recession of 2008/2009, margins contracted significantly, and it made the P/E ratios appear very high.  In reality, 2009 was the buying opportunity of a lifetime. 

Because of these distortions, my preferred metric is the CAPE (Cyclically Adjusted Price Earnings) ratio.  It compares today’s stock market prices to the average earnings over the past ten years so the earnings are smoothed out and better reflect the company’s future earnings power.  Ideally, the period of time should include both recessions and peaks.  The other important point is that when looking at all the valuation metrics (Trailing P/E, Forward P/E, Price to Book Value etc) the metric that best predicts future returns is the CAPE.  Which metric has the worst predictive power?  The forward P/E ratio.  The forward P/E is also the one most used by commentators on business networks as it makes the markets appear more attractive than they really are. 

The long-term average for the CAPE is 16.6.  Today we are trading at 25.3.  In other words, we need a 34% correction for the market to be fairly valued.  This is not a prediction.  Markets can remain overvalued for long periods of time, but it is very helpful to know where we are in the cycle when investing your hard-earned money.  If the elevated CAPE of 25.3 reverts to the mean of 16.6 over a 10-year period, it will reduce annual returns by -4.1% per year.

In summary, if you agree with these assumptions, we are looking at 2.1% annual returns over the next 10 years:

            Real Growth               2.3%
            Inflation                      2.1%
            Dividend Yield           1.8%
            Change in P/E            -4.1%
            Total                            2.1%

Plug in your own assumptions if you don’t agree with mine.  I think what you will find is that it takes some heroic assumptions to get to the 15% annual returns we enjoyed over the past 5 years.