The last 15 years saw the third longest bull market in US history. We have gone 5,090 days (almost 14 years) since the last 30% correction. The two bull markets that lasted longer ended in May 1970 (ushering in 12 years of pain) and September 2001 (followed by a lost decade for stocks).
The longer a bull market lasts, the more precarious it becomes. Stocks get expensive and investors get overextended. The final catalyst that ends it may be fairly random. It is often the sort of event that the market would shake off when it was younger and cheaper. The final catalyst is hard to predict and impossible to time. The best we can do is to look for the conditions that presage poor long-term market returns.
There are two approaches that have a reasonable track record of predicting long term returns: valuation and investor positioning.
Valuation
There are many ways to measure market valuation: price to earnings ratio (whether forward or backward looking), Tobin’s Q, market cap to GDP ratio. They mostly agreee with each other, especially at the extremes (which is what we’re looking for).
One of our favorite long-term valuation tools is the CAPE ratio, invented and popularized by Professor Robert Shiller of Yale University (I may be biased because I learned finance from him.)
CAPE stands for Cyclically Adjusted Price to Earnings. CAPE ratio normalizes earnings to reflect the stage of the business cycle: it adjusts them upwards when they are depressed during recessions and downwards when they are overextended during expansions. This makes the CAPE ratio more accurate than the more often quoted price-to-forward-earnings ratio.
Professor Shiller makes CAPE ratio calculations and values available at his website. The data series goes back 140 years all the way to 1881.
Professor Shiller introduced the CAPE ratio in his book Irrational Exuberance, published in 2000, just in time for the unwind of the dotcom bubble. The message of his research is that valuation matters for long-term market returns. Low valuations (such as around 1920 or 1980) are followed by great bull markets. High valuations (such as 1929 or 2000) are followed by bad performance.
The CAPE ratio didn’t do great in identifying the market bottom in 2009. While it dropped by more than half from its 2000 peak, its level was not particularly low. On the other hand, it wasn’t particularly high either, and resembled the level of 1960 which was followed by the roaring 60s bull market.
The current reading of the CAPE ratio is below the 2000 peak but above 1929 and 1969 peaks.
In the book Irrational Exuberance, Professor Shiller plotted a chart of the CAPE ratio level versus subsequent stock market returns over the next 10 years, using real returns to control for the level of inflation. I have updated his chart with data since 2000.
What can we learn from this chart?
First of all, the average real return of US stocks since 1881 is about 6.5% per year. Stocks are, indeed, good investment in the long run.
When the CAPE ratio lies between 10 and 30, subsequent 10 year returns are hard to predict. They could be high, they could be low, but on average they do not differ much from the average long-term market returns.
When the CAPE ratio falls below 10, it’s a great time to be in the stock market. We can expect above average performance in the next 10 years.
When the CAPE ratio rises above 30, we can expect below average performance in the next 10 years.
The current level of the CAPE ratio suggests prospective real returns of -2% to +4% per year. If we add the expected inflation rate of 2% per year, we obtain expected returns of 0% to 6% annualized. Those are not great returns compared to current 3.9% yield on 10 year US Treasuries.
Investor positioning
The pseudonymous blogger Jesse Livermore published a blog post in 2013 where he described an indicator of investor positioning: Average Investor’s Allocation to Equities (AIAE). The AIAE is calculated as the ratio
AIAE = market value of all stocks / (market value of all stocks + total liabilities of all borrowers)
The blog post goes into great depth explaining the rationale for this indicator but it does make intuitive sense. It includes not just stocks held by individual investors but also those held by mutual funds, pension funds, and all other institutional investors. It is therefore immune to changing mix of equity instruments that people invest in, like the shift from holding individual stocks to mutual funds and ETFs over the last 50 years.
The AIAE indicator is computed from Flow of Funds data published by the Federal Reserve which goes back to 1945. We thus have a data series that goes back almost 80 years.
Over the long term, investors’ allocation to equities as defined by the Flow of Funds fluctuates between 25% and 50%. Importantly, this indicator is not directly driven by the market valuation. The blogger Livermore makes the case that valuation is driven by investor allocations. If investors want to allocate more of their assets to stocks, the stock market has to rise unless corporations issue enough new shares to absorb the demand. Historically, the corporate sector has been a net buyer of shares rather then net issuer, so new share supply was not enough to keep valuations the same.
Like the CAPE ratio, the AIAE indicator flagged the extended markets of the late 1960s and 1990s. Unlike CAPE, it made a good call during the Global Financial Crisis of 2009. The AIEA indicator flashed a clear buy sign in 2009.
Let’s look at how well the AIEA indicator forecasts subsequent returns.
Compared to CAPE, AIEA works better. The \(R^2\) of the regression line is much higher (64% vs 28%). The relationship between the level and future returns is clearer: there is no blob of data points that looks random like the CAPE area between 10 and 30.
Current values of the AIEA indicator are even more extreme than CAPE. They suggest real returns of -3% to -4% over the next 10 years, or -1% to -3% nominal returns. They agree with the CAPE ratio that the outlook for equities over the next 10 years is dim.
US stocks have been the locomotive that pulled investors’ portfolios to new highs over the last 15 years. They are unlikely to play the same role going forward.
To meet their goals, investors have to diversify, whether it’s into foreign stocks, trend following, or other alternatives.