You are an investor in the second most overvalued market in history

You are an investor in the second most overvalued market in history.

I’ve spoken a lot about the overvaluation of markets these days.

But just how overvalued are they, and why does this matter?

The S&P’s cyclically adjusted price-to-earnings ratio is now over 33, making this the second most overvalued point in its history.

Well, let me put it this way…

You are an investor in the second most overvalued market in history.

Allow that to sink in.

More overvalued than 2008 – the greatest market event of most of our lives.

As we know, this doesn’t mean markets are going to go down tomorrow… or the day after.

But it does mean a lot of other things.

This week, I’ve become fascinated by the concept of expected returns.

Expected returns is kind of like asking for what you want for Christmas. It’s a good predictor, but not a perfect one. It might be a slight variation on what you asked for, or they might throw the odd lump of coal in there, when what you really wanted was some renewables stocks.

But basically, you know what you’re getting.

It turns out that valuations are incredibly good at predicting what you’re going to get in the future.

Stocks are actually quite like bonds in that regard. When the price goes up, the yield goes down.

Of course, bonds have a fixed coupon, while equity investors are trying to pick companies whose earnings will soar.

The thing is… they don’t very often. Or investors aren’t that good at picking the ones that do. Or, they soar or fluctuate a lot less than we expect.

So it turns out the equities have something that isn’t all that different to a fixed coupon. Let’s just call it a coupon. It’s not quite fixed, but it’s not that unpredictable either.

In fact, valuations are an incredibly good predictor.

What the first chart shows through this link is power of the cyclically adjusted price-to-earnings ratio (CAPE) in predicting returns. CAPE is just a normal price-to-earnings (P/E) ratio, but where a ten-year average of earnings is used to smooth out any quarterly or annual fluctuations, as they can skew things.

The red dots show the annual returns which would be predicted by the CAPE over the next ten years vs the returns which actually came through. You can see how closely aligned they are – there is a strong correlation.

The higher the CAPE, the lower your future returns are expected to be.

This makes sense – if you pay twice as much for a company’s earnings, you can’t expect to make the same return afterwards.

If you buy a Cadbury dairy milk bar for £83.60, it probably will taste of bitterness and regret when you see it in another shop for £1.

Oh by the way, the eighty-three-pound chocolate bar is Tesla.

Tesla trades on a P/E ratio of 1,254x, 83.6x above the postwar average P/E ratio for the S&P of 15x.

(As an aside, when Tesla CEO Elon Musk tweeted about his own company that the “stock price is too high imo”, the analogous chocolate bar was only costing around £19. It’s almost quadrupled since then. Mental.)

Would you buy a eighty-three-pound chocolate bar? Due to margin-chasing shenanigans, there are only five pieces on a dairy milk now, so that’s over £16 per square.

This is how to think about valuation.

Price is what you pay, value is what you get.

The chart in the link above shows that the cyclically adjusted P/E ratio is actually a very accurate indicator. The blue dots show the returns which followed a given CAPE score, and it’s remarkably accurate.

Depending on how much data you use (the last 20 years, or the last 80…), the expected returns differ slightly, but using the table below, and the current Shiller P/E score of 33, try and think about whether the expected returns of the equity market match what you yourself hope and expect to happen.Data source: Advisor Perspectives

Let’s allow for some error, and say that we’ll use the most optimistic data from the 32-34 range, using the last 55 years of data.

The model still predicts that returns will only be in the region of 3.8%-4.8%.

That is bleak.

CAPE models can be extended further though, to give even better forecasts about future returns.

The most impressive I have come across is from Hussman Funds, which has its own MAPE score – a margin-adjusted P/E ratio.

While the CAPE model has a 0.78 correlation to future returns, its own margin-adjusted model has a 0.89 correlation, so it’s incredibly powerful.

According to that particular model, US stock valuations have now surpassed both 1929 and 2000. You can view the charts via here.

As a result, expected returns have never been lower.

In fact, they are negative.

Its model actually predicts negative annual returns over the next 12 years.

Negative returns. For 12 years.

For another way to look at the accuracy of the model, take the fourth chart from the link above, showing the prospective returns for different assets at different, momentous points in time.

The expected returns of the S&P column, far right, are deeply negative, more so than even in February this year, or March of 2000.

Here’s what the CEO of the firm, John Hussman, had to say in 2000…

“Over the past 5 years, the revenues of S&P 500 technology companies have grown at a compound annual rate of 12%, while the corresponding stock prices have soared by 56% annually. Over time, price/revenue ratios come back in line.

“Currently, that would require an 83% plunge in tech stocks (recall the 1969-70 tech massacre). The plunge may be muted to about 65% given several years of revenue growth. If you understand values and market history, you know we’re not joking.”


“The completion of this market cycle is likely to involve a loss in the S&P 500 on the order of 65-70%. I realize, of course, that this sounds insane…

“The problem is that this projection is fully in line with a century of evidence and is consistent with the extent of market losses that would be run-of-the-mill given present valuation extremes.”

You can read the whole piece here.

It’s immeasurably long. It took me a whole afternoon. But it’s brilliant and I’d say those who read the whole thing will be financially better off for it.

I’ll stop there, to give you plenty of time to do so!

But before I go, I must say that in such an environment, the case for gold has rarely been this compelling.

Add to that the crucial factor which our latest research has uncovered, and that long-forgotten investment is set to take centre stage in our portfolios once more.

Have a great weekend,

Kit Winder
Editor, UK Uncensored

PS Click here to find out more about investing in gold stocks, and which market event could send them soaring before the end of the year.

1 Comment
  1. Twanda Claybrook 2 months ago


Comments are closed.

You may like

In the news
Load More