On the basis of a broad range of valuation measures that are tightly (nearly 90%) correlated with actual subsequent S&P 500 total returns over the following decade, we estimate that stock prices are about double the level that would generate historically adequate long-term returns. The chart below presents estimated versus actual 10-year S&P 500 total returns using a variety of methods that I’ve detailed in prior weekly comments, and including a few additional ones for good measure. We presently estimate 10-year S&P 500 nominal total returns of only about 2.7% annually over the coming decade, with negative returns on all horizons shorter than about 7 years.
Needless to say, Wall Street wishes investors to believe that valuations are just fine, and one can hardly watch CNBC for 10 minutes without some reference to stocks being “cheap on forward earnings.” There are clearly useful ways to use forward operating earnings to obtain useful estimates of prospective equity returns (as shown above). But investors should be aware of the profound inaccuracy of valuation estimates based on unadjusted price/forward operating earnings and the “Fed Model” (which largely underlie the “equity risk premium” claims of Greenspan, Bernanke, and Yellen). The fact is that the errors of those models can be predicted in advance from the level of profit margins at the time of the forecast. The higher the level of profit margins, the more these models tend to overestimate future returns, compared with how stocks actually perform in the following years. The glib confidence placed in these models in 2000 and 2007 is enjoying a full – and likely tragic – revival at present.
DYI Comments: John Hussman should have renamed his article "Don't Get Sucked In!" Watching CNBC along with Fox or Bloomberg one would think that stocks are so low that the U.S. market is at a secular bottom. Nothing could be further from the truth. When it comes to John's 10 year nominal return of 2.7% annually he is the optimist. DYI's estimation is 1.3%. That cuts his estimated return by 50%. Needless to say future returns will be poor at best and they will be one heck of a roller coaster ride. With a Shiller PE10 at 25 times earnings downside risk is huge with a potential decline from peak to trough of 45% to 60%.
DYI's portfolio still stands with only 10% in stocks [smallest amount by model] this will not change until improved valuation avail themselves.
Also I would like to remind you that Gold mining stocks have been severely beaten down in price. This is an excellent time to dollar cost average into your favorite mutual fund bringing your asset allocation up to our model of no higher than 25%.
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