Tugging on Fate’s CAPE
The Standard & Poor’s 500 presently bounces along at 4,513. Yet where will the index sit two years from today?
Will the answer alter your retirement plans?
For answers we glance backward… so that we may look forward.
We enjoy setting you upon our hook and dangling you in the air. Thus we offer you these five choices.
In two years’ time the Standard & Poor’s 500 will read:
Have you decided? The answer — the likely answer, that is — you will have shortly.
But before we look back, or look ahead, let us look down…
Long Day on Wall Street
The S&P 500 absorbed a 53-point slating today. The Dow Jones gushed 461 scarlet points to close trading at 34,022. The Nasdaq gave back 283 points of its own, equally red.
The circulating explanation? The Omicron variant has breached the nation’s defenses. Today the United States reports its first case.
We hazard Dr. Fauci is in clover. It gives him something more to yell about.
Meantime, gold scratched out a $4.40 gain, while Bitcoin has fallen $665 backward as we write.
Ten-year yields, meantime, slipped to 1.43%.
So much for the present turbulences and effervesserences. But what about the all-important future? For as we have declared before:
The fleeting fancies of the market, its momentary moods, its passing passions, hold little fascination for us.
They amuse us – at times, impossibly. Yet they do not fascinate us.
It is instead the grand sweep that fascinates us, the long view. We seek the perspective of the circling eagle high overhead.
And so we begin by glancing backward… 21 years backward… to September 2000…
“This Time Is Different”
The CAPE ratio for the S&P 500 hovered at a preposterous 44.2 — the highest ever.
CAPE’s 20-year average goes at 25.6. Its average overall reads 16.82.
We will spare you CAPE’s inner wizardry.
But know this: Going by the CAPE ratio, stocks had never been costlier — not even in 1929 when the ratio read 30.
“This time is different,” said the crackerjacks. It was a new era dawning. Conventional metrics such as price-earnings ratios counted nothing, they exulted.
Mr. Michael Lebovitz of Real Investment Advice, in reflection:
In 1999, equity valuations stood at unprecedented peaks, even dwarfing those of 1929. At the time, investors were euphoric as if the rally were eternal… Investors bought the narrative with little to no due diligence.
Of course that time proved no different whatsoever.
The S&P 500 proceeded to shed 15% over the following decade — a decade punctuated by two severe hemorrhagings.
The Nasdaq 100 plunged a vicious 55% across the same space.
Now come home…
Second-Highest Valuations Ever
At 40.1, today’s CAPE ratio on the S&P 500 once again exceeds 40… for only the second instance in history.
That is, stocks are very nearly the costliest ever, second only to 1999–2000.
Yet as in 2000, today’s stock market buglers pay little heed to valuations.
They assure us that today’s low interest rates warrant these stratospheric valuations. Stocks are not nearly so costly as valuations indicate.
“Besides, the Fed has our back” is the tune they whistle.
“Sound familiar?” asks Mr. Lebovitz, adding:
Not only is today’s speculative environment eerily similar to the late ’90s, but valuations, in many cases, are frothier than that period.
It does sound familiar, all too familiar. The lyrics may differ somewhat but the tunes rhyme in every significant respect.
They are both merry little ditties. They are dance music.
The Music Stops
The band put down its instruments in 2001 and the dejected dancers abandoned the floor.
Lebovitz warns the instruments are likely to go silent again — soon rather than late.
Today’s impossible valuations can only be justified by the prospects of double-digit economic growth:
Conservatively speaking, current valuations are on par or greater than those in 1999 and any other period. Such a statement is statistically factual, but it ignores the economic environments of both periods. For instance, if you think the economy and corporate earnings will grow at double-digit rates for years, we can make the case valuations are fair today.
Will the economy and corporate earnings grow at double-digit rates for years? It is unlikely.
Too Indebted to Grow
Both public and private sectors have too much debt sitting down upon them… great millstones around the neck.
In 1999 the United States debt-to-GDP ratio came in at a bearable 54%. Today it goes at 125%.
Private debt-to-GDP registered 181% in 1999. Today it stands at 235%.
Earnings were expanding at 7.46% in 1999. Today earnings are expanding at 6.70%.
Productivity growth pegged along at 5.04% in 1999. Today it stagnates at 0%.
The Federal Reserve’s balance sheet totalled $860 billion in 1999. Today it bulges to an obese $8.57 trillion.
“Investors Were Better off Paying Higher Valuations in 1999 Than Today”
Lebovitz in bleak summary:
Economic and earnings growth rates today are weaker than 20 years ago. Further, debt levels, measured as a ratio to GDP, are much higher today. Productivity growth and demographics, two significant factors determining economic growth, are weighing on economic growth today. In the ’90s, they were strong economic tailwinds.
… the amount of monetary stimulus via low-interest rates, and the Fed’s enlarged balance sheet is much more accommodative than in 1999.
Fundamentals and the economic/earnings outlook are weaker today than in 1999. As a result, investors were better off paying higher valuations in 1999 than today… The bottom line is investors are paying more and getting less compared to 1999.
Did you catch that? “Investors were better off paying higher valuations in 1999 than today.”
That is, today’s 40.1 valuations have less excuse in the facts than 1999’s 44.2 valuations.
Likely economic growth cannot justify them. Yet here they are.
Tugging on Fate’s CAPE
So where will the S&P 500 sit in two years? In reminder, your choices are these:
Lebovitz claims a robust correlation between CAPE valuations and 20-year returns.
The lower the initial valuation, the greater the future returns. The higher the initial valuation, the lesser the future returns. For example:
In 1982 the S&P 500 traded at 111. Based upon valuations, investors could have expected S&P 1,068 in 2002.
At the opening of 2000 the S&P had outraced expectations, sprinting ahead to a jolly 1,450.
But the laws of statistics would not be so easily conned.
In 2002, precisely on schedule — like Mussolini’s trains — the S&P came in at 1,068.
Has any clock ever run truer? Now we turn our attentions to the following 20-year stretch, ending in 2023…
The S&P in 2023
In October 2003, the S&P went at 1,019. Going by existing valuations, the same S&P should register 2,655 in October 2023.
The S&P 500 currently sits near 4,600 — high above its 20-year projection.
If the 20-year clocks hold their precision — if they keep true time — the S&P 500 is in for a trouncing these next two years.
How much of a trouncing? A 43% trouncing.
The answer, then, is D.
The S&P 500 will show 2,650 in 2023. Lebovitz:
Assuming the regression holds, and history has favorable odds of that occurring, we should expect the S&P 500 to fall to 2,650 in the next two years. A 43% decline is harsh, but it will only leave the index at fair value based on the last 40 years of CAPE levels. Quite often, markets revert below their means.
The Cost of Every Pleasure
We are therefore in for what mathematical men term “regression to the mean.”
If the S&P regresses to near its historical mean… to its historical mean… or past its historical mean… we do not pretend to know.
Our crystal is cloudy.
The Federal Reserve may even keep the show running through 2023.
Yet as the great Buddha never said: “The cost of every pleasure is the pain that succeeds it.”
Perhaps it is best to get it over with and have done. Delay will only magnify the eventual agonies…
Managing Editor, The Daily Reckoning