History’s best stock market indicator is flashing red right now, indicating a high probability that future equity returns will be far lower than average.
No investor can afford to ignore this warning. So let’s take a look at what it is, how it works and why it matters.
I’ll start by emphasizing that no one – and no system – can accurately and consistently predict the short-term fluctuations in the market.
(For details, see my column about my recent debate with Dr. Mark Skousen.)
What will drive stocks higher or lower next week or next month is next week’s or next month’s unexpected news, good or bad.
It’s not possible to know that news today. (Otherwise, it wouldn’t be unexpected.)
However, it is possible to occasionally gauge whether future returns will be higher or lower than average.
At the market bottom nine years ago, for example, with valuations dirt cheap and sentiment overwhelmingly negative, I set aside The Oxford Club’s traditional market-neutral approach and suggested that we were looking at one of the great buying opportunities of our lifetime.
It has been. Oxford Club Members are sitting on dozens of highly profitable positions – and have locked in literally hundreds of profits over the past nine years.
But was this a smart move or just dumb luck?
A study by The Vanguard Group reveals it was the former.
The mutual fund giant discovered that during the period from 1926 through 2011, the best determinant of long-term future stock market returns was not interest rates, economic growth or earnings expectations.
It was stock market valuations.
When investors bought during periods when stocks were inexpensive relative to sales, earnings, book value and dividend yields, they prospered handsomely.
When they bought during periods when stocks were richly valued, they did far less well.
A study by Crestmont Research is even more illustrative. It looked at rolling stock market returns between 1919 and 2017 and sliced them into the best and worst deciles.
The worst 20-year periods averaged 5.2% annual returns. The best averaged 15.4%.
That’s an enormous variation, turning a $100,000 portfolio into either $280,000… or $1.75 million.
How could you have earned the higher return? By investing when starting valuations were cheap.
Conversely, buying when valuations were high led to much-lower-than-average returns.
This should be disconcerting for today’s buy-and-hold investors.
After all, the S&P 500 is currently selling for 24 times trailing earnings. That’s a full 50% higher than its long-term average price to earnings of 16.
Does this mean you should sell your stocks?
No, it does not.
History shows that stocks regularly go from fairly valued to overvalued… and from overvalued to crazily valued, before returning to undervalued.
(As economist John Maynard Keynes pointed out, there is nothing as disastrous as a rational investment policy in an irrational world.)
That’s why we are happy to take advantage of others’ folly by running trailing stops behind our individual stock positions. This allows us to continue profiting even as they bid stocks up to unsustainable levels.
Moreover, we also rebalance our portfolios annually, selling those asset classes that have appreciated the most and adding the proceeds to those that have lagged the most.
(This both reduces our risk and increases our returns.)
Investors who look at the performance of the S&P 500 over the past decade and expect it to do something similar in the decade ahead are in for a rude awakening.
As the Vanguard and Crestmont studies show, that is highly unlikely.
Active investors, however, can take solace in the fact that there will always be individual stocks that outperform the market averages.
And certain sectors remain undervalued today.
U.S. value stocks, for instance, are unusually inexpensive relative to growth stocks. International stocks are inexpensive relative to domestic stocks. And emerging market equities are the cheapest of all.
Investors should recognize this – and act on it.
With stocks, what you pay is what you get. Valuations matter.