With equity investors jumping on the Trump bandwagon, pushing the S&P 500 up by 3.5% since just prior to the election, we thought we would share some of our long term, bigger picture thoughts on equity markets.
The vast majority of people seem to think that the wealth of a nation can be measured by the performance of the stock market. This is in some respects understandable, as the media forever come up with headlines linking economic performance with that of the stock market. However, the stock market is simply the price that we pay for owning the underlying wealth generating assets. Price can change because of a very small trade whilst the performance and value of a company barely changes on a day to day basis.
So, what is the wealth of a nation? Can it be measured accurately? And how can investors profit from owning a share of that wealth? John Hussman (who really is a must read for those who want a good perspective on market valuation and the fundamentals that matter) describes the wealth of a nation as;
“Broadly defined, [the true wealth of a nation] includes a nation’s accumulated stock of real private investment (e.g. housing, capital goods, factories), real public investment (e.g. infrastructure), intangible intellectual capital (e.g. education, inventions, organizational knowledge and systems), and its endowment of basic resources such as land, energy, and water”.
Shares quoted on the stock market obviously tap into some or all of these resources in some way, and a well-managed system that encourages, incentivises and protects its wealth will deliver prosperity. Fail to encourage productive investment at every level, and you’ll find an economy in long-term decline.
In our opinion, the US has been poorly managed in recent decades (as have many advanced and emerging economies). Yes, we have seen periods of rapidly rising share prices, and we have also seen periods of great technological advancement. However, there is no doubt that productivity has been extremely poor, especially post GFC and the three major bull markets of the last 20 years that have been supported if not encouraged by central bank policies. Now that a Trump presidency appears set to offer a different outcome from the status quo that has dominated for a decade or two, the question is whether his policy mix will increase the wealth of the nation, and if so, how can investors benefit from this.
Back to one of the questions posed earlier, can the wealth of a nation be measured accurately? The simple answer is - no it can’t; not with the available data. Although we could try and build a sort of balance sheet and hold assets such as housing, capital goods, factories and public infrastructure at say book cost or fair value but how should we value intangible intellectual capital and basic resources. We have not ever seen this attempted, and so economists have come up with a short cut known as Gross Domestic Product. This is how we measure the size of an economy, and although we know that it has many flaws, it is the best short hand we have. Now that we can define wealth, and accept that GDP is a crude short hand for measuring the wealth of a nation on an annualised basis, we need to understand how the value of the stock market relates to GDP, and how investors can profit from the wealth of a nation.
We have shown this indicator a few times in the past (the so-called Buffett indicator). Chart 1 below from John Hussman shows the market cap/GDP in blue (inverted). It also shows the subsequent nominal annualised total return over the following 12 year period in red. The correlation between the two is extremely high at over 90%. With the current reading of market cap/GDP at its third most extreme in at least 100 years of data, we should not expect future returns to be anything but below average. Yes, if Trump manages to generate a much improved economic outcome, we have to believe that the returns from holding equities over the next 12 years will be better than the 2% predicted by this model, but probably not by much.
Chart 1 – Market cap/GDP and subsequent 12 year nominal annualised total returns
The reality is that we do not expect Trump to generate meaningful improvement in the performance of the US economy. He is likely to spend money on infrastructure and lower the headline corporate tax rate, but unless he encourages productive private capital formation, improves the educational base of the workforce and manages the basic resources of the country better, any improvement will be modest and won’t affect the expected market returns.
Here, we would like to introduce a chart from Crestmont Research that we may have used before. Chart 2 below shows the S&P 500 and, in the lower panel, the price to earnings ratio of the market using 10 years of data. Crestmont have separated out secular bull and bear markets, defined as movements in the P/E ratio rather than price. Investors should be acutely aware of the price they are paying as measured by the P/E ratio in this example. This chart really does show that it pays to be involved in the market during secular bull markets and it’s best to avoid equities in a secular bear, even though price may not actually fall from the peak P/E to the trough P/E.
Chart 2 – The Crestmont P/E chart
So, intuitively we think that investing into equities for the long term makes sense, but really what we should be thinking is that investing into equities for the long term makes sense when the price to earnings ratio is at or below average. However, when the P/E ratio is at the expensive end of the historical range as it clearly is today, even though we are arguably 16 years into the current secular bear market, returns are very likely to be sub-standard. To attack this from a slightly different angle, rather than divide historical returns into secular bull and bear markets as Crestmont have done, chart 3 below (courtesy of Lance Roberts at Real Investment Advice) shows the rolling 20 year REAL returns from US equities and the cyclically adjusted P/E ratio or CAPE.
Chart 3 – US equities rolling 20 year REAL returns and the Cyclically Adjusted PE ratio (CAPE)
What is obvious from this chart is that peak valuations follow on from periods of strong price appreciation, and vice versa. What really fascinates us is that history shows that there have been quite long periods when 20 year rolling real returns have in fact been negative despite the widely held belief that equities are the best long term investment. What is less obvious from this chart is that after three of the strongest post WWII bull markets in the last 20 years, REAL returns have been just a little over 5% annualised, and that’s the good news. With valuation extremely rich, and the likelihood that we are still in a secular bear market (as described by Crestmont), we can’t really expect returns over the next 10 to 20 years to be above average.
From our thinking, Trump is unlikely to deliver an economic miracle and unlikely to create an environment in which the true wealth of the nation grows at a faster rate than that seen historically. Even if he does, investors are paying a very high price to participate in the equity markets. Historically, it is best to assume that annualised nominal total returns over the next 12 years or so will be barely positive, and real return over the next 20 years will be modest, perhaps even negative.
This is not to say that there will not be opportunities to get bullish in the years ahead, but to be so from either a cyclical or secular standpoint, price has to fall considerably. How much could price fall by? According to the market cap to GDP model, in order for potential future returns to be in the 10% area, the S&P 500 will have to fall by between 40% and 55%. To be able to offer the opportunity of greater returns, price would have to fall even further, and if that were to happen, the cyclically adjusted P/E ratio would decline to a level that would indicate the start of a new secular bear market.
Of course anything can happen in the short term. The current momentum in the market could carry the market higher in the weeks and months ahead which would no doubt delight traders. However, investors really do need to consider whether being invested into equities today is going to generate the returns that they are expecting or hoping for in the next 10 to 20 years. Frankly, we think that buy and hold investors will be extremely disappointed by future returns, and are likely to endure a bear market similar in magnitude the 2000/2003 and 2007/2009 declines.
What is different from the previous two bear markets is that there are no obvious alternatives to equities. Whereas bonds and cash both offered yields of over 5% in 2000 and 2007, today the yield is nearly zero for cash and not much more than 2% for a well-diversified portfolio of government and corporate bonds issued in US Dollars. So, with prospective returns likely to be very modest from all mainstream assets in the years ahead, we continue to believe that investors need to think about style diversification instead of asset class diversification. Although there can be no guarantee of success, managers who have a more flexible trading style may well generate better returns in the years ahead than those generated from a buy and hold position, and with perhaps less risk.
However, what seems rather perverse to us is that ETF flows indicate that the average punter is investing into index funds like never before, and arguably locking into a buy and hold strategy at possibly one of the worst time in the last 100 years. It appears to us that passive investors really are just focusing on the upside whilst forgetting that bear markets do come and go. To illustrate just how frustrating the passive approach can be if an investor buys at the end of a bull market, we have calculated the total nominal returns from a peak to peak perspective (i.e. a whole cycle of a bear market and the subsequent bull market) from March 2000 to Oct 2007, from Oct 2007 to the present, and also from March 2000 to the present.
Peak to Peak annualised nominal total returns
|Equity Market||Mar '00 to Oct '07||Oct '07 to Oct '16||Mar '00 to Oct '16|
This peak to peak type analysis (and yes, we have assumed a peak right now, but just for illustration purposes) illustrates that the buy and hold approach does generate positive returns, but once costs (albeit relatively small in a passive Index) and inflation are taken into account, the returns look pretty miserly especially when an investor has to live through a very painful bear market during a full cycle.
So, to try and wrap up. Although the market seems very content to buy into the Trump reflation narrative, our suspicion is that his policy mix will not improve the US’ economic performance over the long-term, and the “wealth of the nation” will continue to grow in line with historical trends. The price that investors are paying to get exposure to the wealth of the US is extremely rich today for those who profess to be long-term investors. At best, this group needs to manage their return expectations as the next 10 to 20 years are likely to be disappointing (as the last 16 years have!). For those that can be patient, and are happy to wait out the current bullish market narrative, we fully expect much better opportunities in the next few years to invest with the potential to generate high single digit of even double digit returns. These opportunities will be seen after a significant decline in price and P/E ratio.