If only my crystal ball was clearer … fortunately though, no crystal ball is needed to see that equity markets are expensive. According to Robert Shiller’s latest data, the S&P500 is back in its highest valuation quintile. The risk is there – as it always is – but the returns aren’t. So what do you do? Go take a holiday if you can.[sic]
The chart above shows the 10y real returns which have accrued to investors using each valuation quintile as an entry point. If history is any guide, those investing today can expect a whopping 1.7% annualised return over the next ten years.
Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would not be consistent with the findings to bank on above-average returns based on the current ten-year normalized valuation levels. As a matter of fact, there is a distinct possibility of some negative returns off current price levels.
If we combine a reversion to the mean in valuations with a reversion to the mean in profit margins, forward expected returns look very gloomy indeed. Morgan Stanley’s team concludes that a combination of these factors would model an expected real return to stocks of -7% to -8% over the next decade.
Previous posts on this blog have offered evidence that markets, and the economy, are too complex to enable accurate forecasting. Therefore,we are not attempting to forecast forward economic growth, or what the markets will do over the next few months. Instead, we are using new information with a strong proven correlation to the market’s forward returns to adjust the likely range of returns from a buy and hold strategy going forward. A drunk driver may never crash, but the odds of a crash are certainly higher than for a sober driver. In the same way, expensive markets may get more expensive (witness 1994 – 2000), but the odds are long on that outcome.
Fortunately, investors can adopt strategies other than buy and hold that have a much higher probability of delivering strong, consistent returns. We have discussed systematic strategies before, and we will touch on them again in the next post, along with their potential to positively impact investors’ lifestyles in retirement.