Mark Hulbert
writes in the The Wall Street Journal
that all eight of the most historically accurate long-term (10-year) valuation metrics he's found for the S&P 500^a are running hot, implying that S&P 500 returns are "likely to be well below historical norms" over the coming decade. The range of expected annual real (i.e. after inflation) returns given by the eight valuation metrics is currently -3.9% to +3.6%. For some perspective, the S&P 500's average annual real return over the last 200 years is north of +6.6%.
As fundamental, long-term, valuation-sensitive investors, we are well acquainted with these eight metrics, and agree with Hulbert's message that investors putting money into the S&P 500 today should expect modest, if not severely disappointing, 10-year returns. Fortunately we have a go anywhere, active mandate from our clients, which allows us to underweight the US market in favor of more attractive investments overseas.
Below is Hulbert's description and current measurement relative to its average since 1954 for each of these eight valuation metrics, in order of most to least accurate predictors of 10-year real returns as measured by
coefficient of determination (R-square):
The most accurate of the indicators I studied was created by the anonymous author of the blog Philosophical Economics. It [household equity allocation] is now as bearish as it was right before the 2008 financial crisis, projecting an inflation-adjusted S&P 500 total return of just 0.8 percentage point.[...]
The blog’s indicator is based on the percentage of household financial assets—stocks, bonds and cash—that is allocated to stocks. This proportion tends to be highest at market tops and lowest at market bottoms.
According to data collected by Ned Davis Research from the Federal Reserve, this percentage currently looks to be at 56.3%, more than 10 percentage points higher than its historical average of 45.3%. At the top of the bull market in 2007, it stood at 56.8%. [...]
So, here’s a look at those other indicators [...]:
• The Q ratio [...], which is calculated by dividing market value by the replacement cost of assets—was the outgrowth of research conducted by the late James Tobin, the 1981 Nobel laureate in economics.
• The price/sales ratio [...] is calculated by dividing the S&P 500’s price by total per-share sales of its 500 component companies.
• The Buffett indicator [...], which is the ratio of the total value of equities in the U.S. to gross domestic product, is so named because Berkshire Hathaway Inc.’s Warren Buffett suggested in 2001 that is it “probably the best single measure of where valuations stand at any given moment.”
• CAPE, the cyclically adjusted price/earnings ratio [...]. This is also known as the Shiller P/E, after Robert Shiller, the Yale finance professor and 2012 Nobel laureate in economics, who made it famous in his 1990s book “Irrational Exuberance.”
The CAPE is similar to the traditional P/E except the denominator is based on 10-year average inflation-adjusted earnings instead of focusing on trailing one-year earnings.
• Dividend yield, the percentage that dividends represent of the S&P 500 index [...].
• Traditional price/earnings ratio [...].
• Price/book ratio—calculated by dividing the S&P 500’s price by total per-share book value of its 500 component companies [...].
Hulbert does present a rebuttal to the bearish signals coming from these eight valuation metrics from Jeremy Siegel, a professor at Wharton and author of Stocks for the Long Run. Siegel points to several issues that may make these metrics less useful than they have been historically — basically that "it's different this time." However, Siegel doesn't point to any valuation metrics that forecast average, let alone above-average, long-term returns for the S&P 500. But this isn't surprising from Siegel as he is a storng proponent of a buy and hold strategy, regardless of market valuations. For Siegel, it's always a good time to be fully exposed to the US equity market.
We think that the typical individual investor can improve his or her returns by following Siegel's buy and hold advice as it eliminates the average investor's tendency to buy high and sell low. Dalbar, a financial research firm which tracks individual investor behaviour, found that the average investor in US equity funds underperformed the S&P 500 by 3.62 percentages points per year over the last 10 years ending December 31, 2017. Some of this underperformance can be chalked up to fund management fees, and trading costs and spreads, but by far the majority is the result of bad investor timing. Returning back to the valuation metric that Hulbert found to be most reliable in predicting future long-term returns, household equity allocation (what percentage of household financial assets are allocated to equities), investors tend to be overweight equities at the wrong time, and also underweight at the wrong time. Said another way, they buy high and sell low. And another: Bad investor timing.
In our humble opinion, we think we can do better than both the average investor and the buy and hold investor over the long term (e.g. through an investment cycle) by using long-term valuation metrics and long holding periods.