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Pricey Market Poses Challenges To Index Investors
May 3, 2010
With the market at or near 52-week highs, investors should ask just what sort of long-term returns they can expect to earn on their investment dollar at today's S&P 500 price of 1202. Furthermore, which metrics are appropriate to help investors anticipate future index returns?
The most commonly shared and overly simplistic view among the media and market pundits alike seems to be that growth is the key determinant of stock market returns. While earnings growth is certainly important, it is not the most suitable indicator of long-term stock market returns.
Here's why: since 1929, the real (inflation adjusted) price of the S&P 500 has tended to experience long-term secular movements (see chart below), in which growth appears to have played only a minor role. Consider the three most recent secular periods, 1968 to 1982, 1982 to 2000, and 2000 to 2009.¹ From 1968 to 1982 real U.S. Gross National Product (GNP) increased roughly 43% while the S&P 500 declined by over 56% in real terms. From 1999 to 2009 real GNP increased by roughly 20% and the S&P 500 shrank approximately 39% over the same 10-year period (see below right).
Woe to the investor who relied exclusively on growth as a market barometer during these periods, as modest economic growth failed to translate into even modest stock market returns.
During the longest bull market in U.S. history from 1981 to 1999, GNP grew at a slightly higher annual rate (roughly 4.1% annually) than it did during the 1968-1981 period (roughly 2.8% annually). The slight increase in growth rates between the two periods cannot fully explain their drastically different return profiles. Another factor at play appears to be valuation, which is largely driven by prevailing interest rates and investor psychology.
Market interest rates play a key role in determining asset values as they help determine the investor's required rate of return for an alternate investment opportunity. A change in interest rates therefore impacts the value of all assets. For example, the present value of a dollar you will receive in the future is worth much less when interest rates are near 10% than when they are near 4%.
All else being equal, falling interest rates serve as a tailwind to rising asset values, and rising interest rates serve as a headwind to rising asset values.
Our research generally supports this assumption. Between 1968 and 1981 interest rates rose from approximately 6% to 14% with a corresponding market decline. Between 1981 and 1999, on the other hand, returns surged as rates fell from 14% to 6.4%. While interest rates continued to fall between 1999 and 2009, this alone was not enough to support market prices. We therefore turn to the second component of valuation, investor psychology, for further explanation.
| Interest Rates on 10-year Government Bonds (as of December 31,) | |
| 1968 | 6.16% |
| 1981 | 13.98% |
| 1999 | 6.44% |
| 2009 | 3.84% |
When investors expect to receive more dollars in the future, they are willing to pay more (through a higher valuation) for those dollars and vice versa. For example, during the very early '80s the U.S. was experiencing a relatively severe recession, extremely high inflation and correspondingly high interest rates. As a result, many investors were extremely pessimistic about the future of the country.
By the end of 1999, however, investor sentiment about the U.S. economy had swung over to exceptional optimism. Many believed the country had entered a new era of increased profitability and growth driven by technological advancements and the internet. The combination of optimism and declining interest rates led to the most overvalued market in U.S. history (see "S&P 500 (1871 − Present") next page). By the end of 2009, the vast majority of this optimism dried up as reflected in the declining Consumer Confidence Index.
The overall lesson learned is that real economic growth is important, but changes in growth expectations and interest rates also play a vital role in determining returns.
Where do we stand now?
The question burning on many investors' minds is whether the market is overvalued today. To answer this, we avoid using the most common measure of value, the price to earnings ratio (P/E), because it tends to throw off erroneous signals at market extremes (i.e., cyclical earnings peaks and troughs). For example, in March 2009, the trailing twelve-month P/E ratio (i.e., price divided by total earnings for the past twelve months) for the S&P 500 was roughly 108x. Most consider earnings multiples of around 15-20x to be normal. An investor looking solely at the P/E ratio in March 2009 would have assessed the market as extremely overvalued. The opposite assessment would have occurred in the summer of 2007 when the S&P 500 had a P/E ratio of roughly 17x earnings and appeared reasonably priced.
Of course, we all know what happened to the market subsequent to each of these points; when the market appeared reasonably priced in 2007, it fell dramatically, and when the market appeared expensive in 2009, it rose significantly. At both points in time, the most recent earnings of the index either over or understated the index's true earnings power. A measuring stick is not particularly useful if it doesn't work at the most crucial points in time. Enter the P/E10 ratio², developed by Graham and Dodd in 1934, and reintroduced into popular use by Campbell and Shiller in 1998. The P/E10 ratio attempts to compensate for such cyclical extremes by smoothing out short-term distortions and would have told the investor that the market was relatively expensive in 2007 and cheap in 2009.
So how does the market measure up now? The chart at right has been divided into four quartiles using historical P/E10 data:
- 19.5x to 44.2x (the maximum ever recorded)
- 15.7x to 19.5x
- 11.6x to 15.7x
- 4.8x (the minimum ever recorded) to 11.6x
Currently, the market's P/E10 is 21.3x, which is above the historical average of 16.3x and well within the most expensive quartile. In general, it has not paid to be an investor in the S&P 500 while the P/E10 was in the top quartile. The historical average and median annual real return to investors in the top quartile of P/E10s has been -0.93% and -0.72%, respectively. While P/E10 ratios for the past decade have been high, investors justified paying such lofty multiples (ones comparable to those of 1929) because of low interest rates. In 1999 and 2000, investors justified paying even higher multiples due to the combination of low rates and extremely positive expectations of future earnings growth.
Not only is the current valuation high compared to the historical average P/E10 of 16.3x, but the 30-year tailwind of ever-declining interest rates has largely run its course. It is hard to imagine a scenario where long-term interest rates decline much further from their current level of 3.68%. Even if rates were to fall further, the conditions that cause such declines would likely be bearish for equity returns (think deflationary bust similar to the 1930s or Japan in the 1990s). The more plausible scenario includes rising rates, thus the interest rate aspect of valuation is likely to be negative in the upcoming decade.
Moreover, sagging consumer confidence suggests stunted expectations for future growth. While an improvement in sentiment would positively impact market valuations, it would likely trigger rate hikes by the Fed.
Steadfast index investors take note: the net effect of these factors leaves little to no justification to believe in further expansion of P/E10 multiples.
The good news is that while the outlook for general index returns looks relatively poor, market volatility and strong fundamental analysis will continue to provide opportunities for dedicated investors willing to ramp up their due diligence. Despite our muted outlook, we believe an actively managed portfolio focused on the long-term will perform relatively well in such an environment. As conservative, risk-averse asset managers, we do not rely on derivatives or leverage to boost returns, so, as always we proceed with a keen eye for intrinsic value.
Copyright 2010 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 4 · No. 5
¹ For ease of comparison and simplicity we have chosen to use 12/31/1968, 12/31/1981, 12/31/1999, and 12/31/2009 as the start and end dates for this study (represented by the stars on the "S&P 500 (Real)" chart) even though the actual peaks and troughs may vary by a few months. S&P 500 data is gathered from Robert Shiller's "Stock Market Data," which is available at http://www.econ.yale.edu/~shiller/data.htm, and our GNP statistics were gathered from Bloomberg, LP.
² The P/E10 takes an average of the index's real earnings over the past ten years, offsetting both inflated and depressed results. The current price (or historical real price) is then divided by the average real earnings of the previous ten years to arrive at the P/E10 ratio.
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