U.S. stocks have more than doubled in price from the crisis-induced low registered during the spring of 2009, and posted the strongest quarterly performance since the late-1990s during the first three months of the current calendar year. The sharp reversal in the stock market’s fortunes, following more than a decade of dismal returns, has prompted previously hibernating uber-bulls to call an end to the secular bear market. They argue that a sustained multi-year upswing in equity prices is now underway.
One sell-side strategist has gone as far as to predict a near-doubling in the Dow Jones Industrial Average to 25,000 over the next ten years, and urges both existing and prospective clients to accumulate exposure now. The arguments employed to justify the high expectations are seductive, but the analysis is less than thorough and does not stand up to serious scrutiny. In fact, a more probing investigation reveals that the decade ahead may well prove to be no more rewarding for equity investors than the ten years that has just passed.
The first line of reasoning to support the bullish forecast rests on the notion that a sustained period of high returns like previous episodes that began in the late-1940s and early-1980s, can be expected simply because the past decade has been so poor. This argument completely ignores the inconvenient truth that U.S. stocks enjoyed a boom unparalleled in American history during the 1980s and 1990s, which saw prices reach unprecedented levels versus their long-term trend line. The uncomfortable reality is that much of those previous excesses have not been erased, despite the dreadful returns of the past twelve years.
Drawing a regression trend line through the real monthly average of the daily market closes dating back to 1871, reveals that the long-term uptrend in real stock prices is less than two per cent from year to year, which not coincidentally, happens to be the same as the annualised increase in real earnings-per-share through time. In other words, stock prices follow the uptrend in the market’s earnings power over protracted horizons.
Unfortunately, the powerful bull market that extended from the autumn of 1982 to the summer of 2000 saw stock prices overshoot the trend by more than 150 percentage points – almost twice the overshoot registered at the secular peak of 1929 and nearly three times greater than the exuberance recorded in the late-1960s. Twelve years later and stock prices are still trading almost 50 per cent above trend.
Simply eliminating this excess would equate to the Dow trading below 9,000 today, but previous secular bear markets have seen real stock prices drop to more than 50 per cent below trend. If history is a reliable guide to the future, the lows registered during the spring of 2009 can be expected to be retested – at least in real terms – at some point in the years ahead.
The second line of reasoning employed to support the bull case is that stocks are currently trading at valuation levels that are close to 25-year lows. However, valuations were already trading above their long-term historical averages by the fifth anniversary of the previous secular bull market in 1987, and moved to the most expensive levels in American history by the late-1990s.
Simply put, an assessment of value that goes no further than comparing current valuations to the most extreme stock market bubble in more than 140 years, can hardly be described as reliable. Indeed, valuation levels at previous secular bear market troughs in 1921, 1949 and 1982 were only a fraction of what they are today. The price multiple on trend earnings dropped to less than seven during each of these previous episodes, which allowed for several years of robust stock market performance, before valuation levels even returned to their historical averages.
In contrast, the U.S. stock market is trading at more than 20 times trend earnings today, which is closer to the levels that prevailed at previous secular bull market peaks than it is to those that were registered at important long-term bottoms. Further, the historical record demonstrates that multiples of 20 to 22 have led to average annual real returns of minus 2.2 per cent over the subsequent ten years, with a median value of minus three per cent – hardly the stuff of wealth accumulation implied by Dow 25,000.
The Dow 25,000 target in 2022 is seen to be achievable given that it implies an annualised nominal price return of less than seven per cent. However, the objective can hardly be described as conservative, since it implicitly assumes that stock price increases will outpace the underlying growth in earnings-per-share for several years.
Assuming that inflation averages between two and three per cent per annum over the next ten years, and observing the fact that real earnings-per-share have grown at an annualised rate of no more two per cent through time, means that the annual growth in nominal earnings should average between four to five per cent in the future. Thus, Dow 25,000 implies that price increases are expected to exceed earnings growth by roughly two to three percentage points a year, which results in a price multiple of 23 to 25 times trend earnings in 2022 – a level that exceeds both the secular peaks in 1901 and 1966 – hardly a conservative outlook.
The uber-bulls are back with extravagant forecasts that appeal to the all-too-human desire for instant rewards. The more astute will be aware that investment professionals are in the business of selling product, a task that is made all the more easier by rising prices and rosy expectations. Those that are seduced are likely to be disappointed.
Previously posted on www.charliefell.com
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