S&P 6000: Irrational Exuberance

WARNING: I am not saying sell stocks today! It was over three years from Greenspan’s irrational exuberance speech until the top of the market.

Rather, I am expressing the need for caution as you think about future stock returns. I have no idea when the top will come or how much higher it will go first.

What I plan to show below is that there are warning signs that the market is materially overvalued and therefore future returns will be below trailing returns.

Most people have an unfortunate proclivity to be most optimistic when they should be most pessimistic. If I help some of you avoid going overboard, I will consider this a deed well done.

Greenspan’s Question

When people think of Greenspan’s quote, they usually believe he said the market was too expensive. That is not what he said. In fact, he didn’t declare anything. Rather, he asked a question:

How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?

Today, I ask the same question. How do we know? As I noted above, we can’t know.

However, we can make reasonable judgments. Let’s make some.

Stocks Are Expensive

You can use a longer term chart than below if you wish, but the conclusion would be the same. Valuation is well above historic norms.

We can no longer justify this with ultra low interest rates making stocks the least bad option. Stocks are flat out expensive, by any measure.

Now, some of you will say, “oh, that’s just the big tech stocks”. No, it’s not just the big tech stocks. See below.

The rest of the market is well above average too at 19X earnings vs. a more normal 15X.

If you don’t like that approach, we can look at individual sectors.

Once again, every part of the market is well above normal valuation.

Now, that doesn’t mean it has to go down. Valuation alone is rarely the cause of a bear market. But it does mean that it is mathematically more challenging for future returns to be above average.

One of two things would have to happen: valuations would have to get even more expensive or earnings growth would have to be better than average. While the latter is possible, it isn’t probable.

Past Returns DO Predict Future Performance

What happens when you buy stocks at well above average valuations? You tend to underperform going forward. There have been many studies documenting that starting valuation is one of the best predictors of future returns (i.e. if you buy at high valuations, you get lower returns in the future and vice versa).

Below, you can see a study from Goldman using this history to show that the mean expected return for the next ten years is just 3%/yr.

A lot of investors reacted pretty negatively to this chart, suggesting it was too pessimistic, but it seems right on the money to me. History suggests we are in the late innings of a bull market and you should reset your future return expectations lower as a result.

I should also make clear the chart doesn’t “predict” 3% long term returns. That’s a median.

You can see there is a forecast range of -1% to 7%, but it’s not the 13% we’ve had over the last ten years.

Think of this chart like an average annual cat loss model. The actual result will surely be different, but the odds that you’ll make 10%/yr are lower than they were if you made this chart ten years ago.

Implications

So what do you do with this information? First, remember, it’s not something to panic over. Second, don’t get carried away and chase if you’ve missed this rally. Doubling down near the top is not advisable!

Think of it like a soft insurance market. You don’t get off every risk, but you set a higher bar for those you write.

Similarly, you don’t stop investing, but maybe you put in a little less new money or perhaps divert a little more to underperforming classes like small caps, value, or international.

One obvious thought you may have is to put more in bonds to “de-risk”. My concern there is if we get a resumption of inflation, you’re not going to do well in bonds either.

The exception would be if you buy a 10 year bond and are certain you will hold it to maturity. In that case, you will earn somewhere around 4.5% which would you get equity like returns with less downside risk.

I’m not recommending that, but it’s not the worst idea either if you are sure you don’t need the cash.

I certainly wouldn’t add credit risk, as that is as overbought as equities.

There are no great answers. If there were, stocks wouldn’t be so expensive.

However, answers will emerge over time, so probably my most practical advice is to keep some extra liquidity available.

For one, cash returns will probably be fairly close to stock returns. But also, when things change, you want to be able to take advantage.

Plan For The Not So Great

Until then, as noted, there’s no reason to do anything drastic like dump all your equity exposure. But you should have lower expectations.

I’m not suggesting plan for the worst, It’s more like plan for the “not so great”. If your spending plans or retirement date depend on the market doubling every five, or even ten, years, that’s probably unrealistic.

The more important question to ask is, if the market is flat for ten years, will you be OK? Because the odds of that scenario are higher than in the recent past.

On a historical note, I should point out the 10 year return after Greenspan’s irrational exuberance speech was about 7%/yr, so not too bad.

However, that is because there were massive returns in the succeeding three years followed by roughly flat returns over the next seven.

I don’t think anyone is suggesting we will double to 12,000 in the next three years, so I wouldn’t count on my exuberance call being as premature as Greenspan’s was.

There are times when being too cautious is bad for your financial future (because of missed gains, such as the last decade).

However, the worse outcome is to be too aggressive at the wrong time. We are getting closer to the wrong time, so more caution is warranted.