By Nicholas Colas of Convergex Last Time US Stocks Were So Expensive, This Happened Summary: The best argument for avoiding US stocks is simple: valuation. Using the Shiller PE Ratio (price divided by a 10 year lookback at earnings), domestic equities trade for 29.9x earnings versus a long run average of 16.7x. The last time they were this expensive was early 2002, or 15 years ago. So how have they done since? The S&P 500 has appreciated 116% (a 5.3% CAGR) since February 2002 on a price basis. With dividends reinvested, that return jumps to 175% (a 7.1% CAGR). Not bad, but not the 9.5% average return from 1928 - 2016 either. As for how we got here, look to Consumer Discretionary (up 197% on a price basis), Health Care (+172%) and Energy (+170%). The largest drag was Financials, up only 10.0% since February 2002. But if the long term is a pretty good story, consider that 1) equities were down 22.0% in 2002 and 2) part of the appreciation over the last 15 years is due to exceptionally low long term interest rates. To get a similar outcome over the next 15 years, earnings growth may be the only driver.
According to the US Government, I will live to the ripe old age of 82.4 years. If I can make to age 62, however, that buys me 3 more years and I will expire halfway through 85. And if I make it to 70, I can tack on almost another year on top of that, within sight of 90. If you would like to see your own expected life span, just click here for the Social Security Administration's "Life Expectancy Calculator": https://www.ssa.gov/cgi-bin/longevity.cgi
My goal, therefore, is to get to 62 years old in decent health. Statistically, that is the easiest way to tack on a few more years of life. And it fits with my mantra on such matters: "The purpose of life is to stay alive." Or, as my doctor tells me, "You're a guy. If you can make it to 60, you can make it to 80".
Equity market valuations play a similar role in estimating future returns - essentially they are one measure of the potential longevity of any given bull or bear market. High valuations point to lower future returns; lower valuations hold the promise of better future returns. Given that low valuations tend to occur during periods of economic and capital markets turmoil when asset prices (and investors) are depressed, this all makes good intuitive sense. Or, as the old trading saw goes: "Instead of crying, you should be buying."
One measure of current US stock market valuation is the Shiller PE, which is simply the price of the S&P 500 divided by the average earnings of the index over the prior decade. Here's how it looks right now:
There are two problems with crying "Fire" in the theater over this number. First, it is not exactly a clean data set. The accounting rules over earnings have changed a lot in the last 100 years, after all. Second, interest rates play a critical role in equity market valuations, and the Shiller PE ignores them entirely. With long rates as low as they are you would expect to see very high equity market valuation. That's just math.
Still, there is some good work out there on how Shiller PEs can inform our perspective on future returns. Cliff Asness of AQR wrote one piece back in 2012 where he looked at 10 year returns on US stocks based on the starting Shiller PE. Here is what he found:
We can take this analysis one step further, and look at what happened the last time the Shiller PE was close to 20; conveniently, it was 15 years ago - right at the start of 2002. What's happened since? A few points:
So if you had gone all-in on US stocks the last time the Shiller PE was this high and waited 15 years, you would have more than doubled your investment. Yes, you would have had to live through some pain first. The S&P 500 was down 22.0% in 2002, after all. And then there was 2008, down 36.6%. On the plus side: over the last 15 years those (2002 and 2008) are the only down years for the S&P 500.
So how did we get a 7.0% averaged compounded growth rate from a relatively high starting point for US stock valuations? Here's how:
Can history repeat itself over the next 15 years? The Shiller PE of today is exactly where it was 15 years ago, after all, and things worked out fine. A few final thoughts:
That, along with lower rates, is what allowed US stocks to break the drag of a high Shiller PE back in early 2002. For the next 15 years, however, earnings will almost certainly have to go it alone if stocks are to replicate the performance of the last decade and a half.
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