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A look at historical returns preceding stock market peaks shows that the fear of missing out at the last stage of a bull market is justified. But piling into expensive stocks with the hope of padding returns right up until a market turns can hurt long-term future returns dramatically.
Being right about an impending crash but acting too early often cuts your short-term performance, especially next to some peers, stressed Savita Subramanian, equity and quant strategist at Bank of America Merrill Lynch.
Total returns of the S&P 500 SPX, +0.73% preceding market peaks since 1937 show that an investor could forego an average return of 25% if they exited the market 12 months before the top. Even getting out six months before, you’d miss a 16% return on average.
Returns at the last year of the market cycle account for a disproportionate part of the returns from the entire cycle, as shown in the table below.
A great example was when Alan Greenspan, then chairman of the Federal Reserve, in 1996 described the overvalued stock market as “irrational exuberance,” only to have the market continue to climb for four more years before crashing.
And just like in 1996, the S&P 500 is overvalued by most metrics. The table below shows that current valuation multiples are above the long-term averages.
This makes forecasting and deciding how to position for the next big downturn very difficult. You may miss the rally in the short term if you are cautious and get burned in the long term if you are too optimistic.
For investors, planning for future wealth and security relies on reasonable assumptions about future expected returns.
Chris Brightman, chief investment officer at Research Affiliates, said that forecasting next year’s returns is a hopeless endeavor, but a 10-year return can be forecast with a surprising predictability.
One of his absolute valuation models calculates long-term returns by adding the current dividend yield to a historical average of real earnings growth and the implied inflation rate.
The current dividend yield is just under 2% for the S&P 500, and according to Brightman, long-term real EPS growth has been relatively constant at about 1.5% a year, though for the next decade it may well be lower.
“Long-term trend of mean reversion implies lower-than-average earnings per share in the future due to a decline in productivity. So, we estimate that EPS growth over the next decade is likely to be at about 1%,” Brightman said.
Dividend yield at about 2%, plus 1% EPS growth and a 2% implied inflation bring us to a 5% expected future return over the next decade, Brightman said, though he cautioned that variability will have an impact.
“In reality, the return for the S&P 500 over the next 10 years could be somewhere between zero to low single digits,” Brightman said.
U.S. government bond returns are even less appetizing, if you consider that the yield on a 10-year Treasury note TMUBMUSD10Y, +0.30% — a proxy for a 10-year return — is currently at 2.4%.
Incidentally, the cyclically adjusted price-to-earnings ratio, known as CAPE or Shiller PE, named after Yale’s Robert Shiller, is near 29, the highest level since 2000. It, too, points to low future long-term returns.
By contrast, average annual returns of U.S. stocks over the past decade, which began with a financial crises and an economic recovery and expansion, have been very close to the textbook historical average, at about 8.7%.
“The outlook is only depressed if you keep your savings in U.S. stocks and developed sovereign bonds,” Brightman said.
But home bias is strong with American investors.
Recent data from the Federal Reserve showed that the equity holding of U.S. households is at the highest levels since the tech boom in 2000. The high levels of stock holdings by households has been associated with low future long-term returns.
While the prospect of long-term returns in U.S. stocks and bonds seem bleak, there are opportunities offering higher risk-return reward in other countries.
Valuations of emerging-market stocks and many developed markets, excluding the U.S. and Canada, are relatively lower and promise higher expected returns.
Brightman has no doubt that U.S. equities are overvalued and his advice is to diversify out of the U.S. and into foreign markets.
“Create a long-term plan which includes a well-diversified portfolio that systematically rebalances,” he said.
“Going by valuations, it seems that the best strategy right now would be to sell U.S. and buy Russia,” he said.