The stock market continues to set new highs, which is exciting and fun for those of us who own stocks.
I own stocks, so I’m certainly enjoying it.
I hope stocks continue to charge higher through 2014, but I can’t find much data to suggest that they will. I only have a vague hope that the Fed will continue to pump air into the balloon, the U.S. economy will finally start cranking again, and corporations will continue to find ways to cut more costs and grow their already record-high profit margins and earnings.
Meanwhile, every valid valuation measure I look at suggests that stocks are at least 40% overvalued.
That doesn’t mean that stocks will crash. But it does strongly suggest that, at best, stocks are likely to produce lousy returns over the next 10 years.
Which valuation measures suggest the stock market is very overvalued?
These, among others:
- Cyclically adjusted price-earnings ratio (current P/E is 25X vs. 15X average).
- Market cap to revenue (current ratio of 1.6 vs. 1.0 average).
- Market cap to GDP (double the pre-1990s norm).
(See charts below.)
How lousy do these measures suggest stock returns will be over the next decade?
About 2% per year for the S&P 500, including dividends — a far cry from the double-digit returns of the past five years and the ~10% long-term average.
If stocks just park here for a decade and return 2% a year through dividends, that wouldn’t be particularly traumatic. But stocks rarely “park.” They usually boom and bust. So the farther we get away from average valuations, the more the potential for a bust increases.
So the higher we go, the less surprised I will be to see the stock market crash.
How big a crash could we get?
According to the aforementioned valuation measures, and the work of fund manager John Hussman of the Hussman Funds, 40%-55%.
A 50% crash would take the S&P 500 below 900 and the DOW below 8,000.
Is that going to happen?
I don’t know. But it wouldn’t surprise me.
One thing I do know is that no one else knows, either. We’re all just dealing in probabilities. And, just as importantly, no one knows when. Valuation measures like the ones above are unfortunately not helpful in predicting short- or intermediate-term market moves. So, maybe the market will continue to move higher through 2014. I certainly would be happy about that.
But a careful study of history suggests that a crash is increasingly likely and that long-term stock returns from this level are likely to be crappy.
I’ve explained in detail here why I think the odds of a crash are increasing. And I’ve also explained why, despite this, I’m not selling my stocks. (In short, because I am a long-term investor, I am mentally prepared for a crash, and I am planning to ride out any crash, the same way I did with the 2008-2009 crash. And also because none of the other major asset classes are particularly compelling investments at these prices, either.).
Importantly, there are at least three sophisticated arguments about why the aforementioned valuation measures are wrong — and, therefore, that “it’s different this time.”
- Interest rates are likely to stay near zero for many more years, and in a near-zero rate environment, the fair value for stocks is much higher than it is in a normal rate environment.
- On average, stocks are getting increasingly less risky — and, therefore, that old “average” valuation measures don’t apply.
- Changes in accounting rules and aberrant earnings performance during the financial crisis have skewed average long-term valuation measures, making stocks look more expensive than they actually are.
Retail Traffic Plunges By “Staggering” 21% In Week Before Christmas
That it has been one of the most lacklustre shopping seasons in recent years has already been repeatedly covered, with average holiday spending expected to decline for the first time since the Great Financial Crisis of 2008, all this despite record promotions and an ever earlier start to Black Friday.
Another chart showing the same trend from Bloomberg, with the comment that the “eroding middle class can no longer drive activity as it has in the past” – that’s odd: we said the same thing in late 2009 for which we got yet another label of tinfoil conspiracy theorists…
Junk Loans Top ’08 Record As Safeguards Stripped
The amount of loans to the riskiest U.S. companies ballooned to a record this year, propelled by unprecedented demand for floating-rate debt that offers protection from rising interest rates.
The market for junk-rated loans increased to $683 billion, exceeding the 2008 peak of $596 billion, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data. The $130 billion surge this year was fueled by borrowings that don’t include typical lender protections such as limits on leverage.
Loans, which suffered the biggest losses in the fixed-income market during the financial crisis, staged a comeback as investors funneled a record $64.4 billion into funds that buy the debt in anticipation the Federal Reserve would start unwinding its bond buying that’s suppressed borrowing costs. The demand has enabled companies take on more debt for shareholder rewards, prompting regulators to warn that the excesses which contributed to the credit crisis may be creeping back.
- China’s local government debt seen at $3 trillion as of end 2012
- China’s $50 billion move to avert cash crunch
- Junk Loans Top ’08 Record as Safeguards Stripped
- Venezuela Devalues Bolivar for Tourist Dollars to Boost Reserves
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