Looking at the chart below of the Dow Jones Global Index, an index covering stock markets around the world, shows a repeating stock market cycle taking place over the last 20 years. In the first 2 cycles, we generally saw steadily increasing stock prices for five years or so, roughly doubling, then collapsing by about half over a period of about two years, before repeating the cycle. The decline in the most recent stock market cycle may have been temporarily abated in 2011, but may now be commencing its last act.
Back in 2009, in response to financial panic and stock market selloffs taking place, central banks around the world drove interest rates to record lows and printed money like never before. In response to the various programs of “quantitative easing” and interest rate suppression in the years following, global stock markets soared. As visible from the chart we see that, in this latest cycle, instead of taking five years for the stock market to double after the crash ending in 2009, in this latest up cycle it took less than two years for global stock markets to double.
In response to such sharp gains, and with economic growth slowing, by mid-2011 it appeared that worldwide stock markets were likely to see severe declines. But this time it was different, as markets thereafter fell about 20%, not the 50% or so declines seen in the prior two Bears. What was different from prior declines, were the extraordinary efforts the Federal Reserve was undergoing to keep interest rates down and to flood the economy with money.
Amid the market downturn in late 2011, the Fed unveiled another round of “quantitative easing” accompanied by a $400 billion “debt-swap” and mortgage purchase program to lower interest rates even further. This would have the immediate effect of boosting the stock and bond markets, and simultaneously encourage consumers, businesses and governments (many already over-indebted) to borrow and spend more. The Fed and government officials were doubtless pleased as markets and spending followed their desired course over the following months and years. So instead of the deeper market correction that might have dissipated some of the overspending, overbuilding and misallocation around the world, stock markets quickly resumed their upward climb, tacking on additional gains of more than 50% within 3 years.
Yes, Valuations Still Matter
In recent years, markets have become increasingly divorced from market fundamentals, and more responsive to the level of interest rates and the amount of money sloshing around the globe. However, historically, stock market valuations have mattered – a lot, especially in the long run. Generally speaking, when price-to-earnings ratios are at the higher end of historic averages, long-term returns in the years following tend to be lower. The chart below compares then-current price-to-earnings ratios and their subsequent 5-year returns. There is an obvious negative correlation. We see that when starting P/E ratios have been 10 or below, subsequent average returns have been quite high, averaging more than 15% per year. Conversely, when P/E ratios have been at levels of 20 and above, the following 5-year average returns have been negative. Similar results are seen comparing P/E ratios and 10- and 20-year subsequent returns.
This is worth remembering today when, despite the recent market pullback, stock market valuations are still very elevated. Latest S&P 500 earnings for the 12 months ending June 30, 2015 were about $94/share. Current earnings expectations for the full year are about $90/share (which may actually be inflated as weaker worldwide economic growth now appears likely). Using $90/share and the current level of the S&P500 index – 1907 as of January 22, 2016 – the U.S. stock market trades at about 21 times earnings. The Schiller P/E ratio, which is based on average inflation-adjusted earnings from the previous 10 years, is currently 24, about 50% above its historic average. This index has only been higher amid the late 1920s stock market bubble, the late 1990s dot.com bubble, and the real estate/credit bubble of the mid-2000s. For this index to fall to its long-term average, the U.S. market would have to fall by another third.
If the market is spared a crash, the market is still unlikely to produce bountiful gains from here. At current levels, and based on past results, the Schiller index predicts that over the next 10 years, the U.S. stock market will average a 1% yearly average return. Worse, if those 1% average returns do come to pass, they will also be laced with both volatility and investment expenses, which will increasingly turn investors away from the market. If investors knew that the stock market was only going to average 1% per year for the following 5 or 10 years, with all the associated volatility, few would invest, and rightly so. It would instead be preferable to earn a guaranteed 1% on a CD or maybe even 0% in the bank than to invest in a stock market averaging 1%, with 100% chance of volatility. In addition, the additional price of investing is the cost - to trade, for commissions, management fees and so on. Those fees often add up to 1% or 2% per year or more, thus further erasing meager returns.
Such predictions of investment returns are impossible to know of course, but to be sure, the lofty valuations of today do not generally foreshadow high future returns. That is helpful to remember today, that despite suggested yearly investment returns of 10% or more a year often touted by advisors and financial planning calculators, such high returns are unlikely to appear.
Although past is no guarantee of the future, and one cannot discount the extents the Fed will undergo to levitate stock market returns, valuations at today’s level has not historically led to high future returns. For example, when P/E ratios have been at 20 or above, as they are now, the U.S. stock market has never delivered average returns of 10% or more for the following decade. After investment fees and the typical underperformance of mutual funds and individual investors (for more on that, you can look at my book, Let Your Money Grow, at Amazon), and there is little reason to be optimistic for investment returns over the next 10 years, stock market crash or not.
Will a Market Crash be Avoided?
For now, stock investors and traders are interested in the short term, where the stock market will go in the next few days, weeks and months. The Federal Reserve will be one of those watching markets closely and ready to “intervene” if they feel the need to do so. Time and time again, the Federal Reserve has made it clear that they will do whatever they can to boost or support the stock market. That was the reason behind the bailout of the Long-Term Capital Management hedge fund back in 1998, which perhaps was the beginning of the Fed’s micromanagement of the stock market (yes, the secretive “Plunge Protection Team” had already been in place for a decade at that point, but not to the extent and control achieved by the late 1990s).
Yet so far this year, the Fed is talking tough that despite the fracturing stock market, the Fed will not intervene in the markets, despite doing so repeatedly in the past. In early January, Federal Reserve Bank of San Francisco President John Williams said he still expected the Federal Reserve to raise interest rates roughly each quarter, for a total of about 1% in 2016. He also said that swings in the stock market have not “fundamentally” changed his expectation for “moderate” economic this year and that the market sell-off will not affect the Fed’s decision-making. That’s hogwash, of course. The Fed is acutely aware of the deepening extent that stock markets affect the economy, instead of the other way around. And for more than two decades, the Fed has made no secret of the fact that their money-printing and interest-rate manipulations have often been with the intent of boosting stock and bond markets, and spending, via the “wealth-effect”.
Federal Reserve Bank of Cleveland’s head, Loretta Mester, also told a whopper in early January when she said that the Chinese economy “was not a significant risk” to the Fed’s economic forecast and their policy expectations. In reality, you can be sure that the Federal Reserve is sweating bullets these days with eyes glued to their Bloomberg terminals covering markets in China. The Fed’s denial of China’s economic importance to the U.S. and globally is rather shocking since it is lack of Chinese demand that has collapsed commodity prices and economic conditions across much of the globe. It reminds me of when in 2007, then-Treasury Secretary Paulson denied obvious signs of economic weakness across the world when he said that the financial market turmoil was happening “against a backdrop of a very healthy global economy with strong fundamentals.” Quite a statement considering the months following and the worldwide financial collapse.
Make no mistake, the Fed will soon return to its core mission, boosting the stock market and flooding the economy with cheap credit. Whether that will lead to the stock market surging higher once again or the Fed will discover that its actions have become increasingly powerless as markets focus on true economic fundamentals, not the amount of money that will be pushed through the economy.
If this current downturn lead becomes a “crash”, similar to those of 2000 and 2008, it again will prove that all artificially boosting stock markets do is borrow from the future. It does not guarantee perpetually elevated returns. It instead leads to more volatility, bigger booms and crashes, misallocation of resources and broken investments and savings. For individual investors, their long-term investment returns certainly are not improved by Fed-induced market “management” and are most likely hindered as investors scramble to save their declining nest egg once the inevitable market rout eventually comes.
Slow and steady is supposed to be path to success in investing, but is admittedly difficult with the Federal Reserve artificially boosting stock markets, lowering interest rates to nearly nothing on safe investments. Investors become speculators, not realized until it’s too late. Unfortunately with high stock market valuations, like those that exist now, the risk of a true crash is not unlikely. This is the time to be honest with yourself and decide whether you will buckle up for the ride come hell or high water or decide that you and your portfolio just can’t bear today’s risk.