In December 1996, then Federal Reserve Chairman Alan Greenspan gave a speech
in front of the American Enterprise Institute and posited what the central bank should do when investors’ “irrational exuberance” pushed asset values to a level that would compromise future returns:
"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?"
At the time the S&P 500
(INDEXSP:.INX) was trading at 757 and was up 72% from December 1994. Ultimately Greenspan did nothing to curtail this exuberance, and stocks would go on to rally another 61%% into the 1998 Long Term Capital Management hedge fund implosion.
Greenspan “came to the rescue,” introducing his eponymous put option. After be given the green light, stocks went on to rally another 68% into the 2000 highs that culminated with the technology bubble blow-off top. These years would see some of the most robust financial returns in history, but as we now know, this was at the expense of returns during the decade that would follow.
Fast-forward to this week’s Janet Yellen Senate confirmation testimony where Republican Senator Mike Johanns of Nebraska asked Ms. Yellen, “What am I missing here? I see asset bubbles.” Ms Yellen’s response was, “We have to watch this very carefully, but I don’t see this as an asset bubble.” This exchange prompted Wall Street Journal
writer Joe Light to ask the question on every equity investor’s minds: Is This a Bubble?
It seems the stock market goes up every day, and the more it rallies, the more we hear about the prospects of a bubble. Bulls will tell you we aren’t in a bubble because valuations remain modest relative to history, especially when compared to previous stock market bubbles. Bears will tell you we are in a bubble because assets are being artificially inflated by the Fed’s quantitative easing and zero-percent interest rate (ZIRP) policy. I would say that asking whether we are in a bubble is asking the wrong question. The real question equity investors should be asking is what this historic rally portends for future returns.
In December 2011, McKinsey & Co. published a thorough study of the equity market titled The Emerging Equity Gap
. It included a chart of rolling 10-year annualized equity total real returns using the Shiller S&P composite index. The chart included 10-year annualized returns dating back to 1881, and there was a definable bell curve-like distribution between 17% on the right tail and -4% on the left tail with a median return of 7%. At the time, McKinsey wanted to show that the negative 10-year returns during 2008 (-4%), 2009 (-3%), and 2010 (-1%) were in the left tail and thus very rare in history. However it is the right tail of the distribution of 10-year annualized returns that I think investors need to be aware of today.
Last week in Monetary Policy Myths Debunked
, I highlighted the disparity between economic and market performance:
"The vast majority of market participants believe the 10-year Treasury yield is at this 2.50% level because of quantitative easing. But think about the economic benchmarks for growth. The growth rate of nominal GDP is around 3%. The growth rate for consumption is around 3%. The growth rate for inflation is around 1.8%. The growth rate in wages is 2.2%. The growth rate for S&P 500 revenues is 2.9%. With the exception of recessions, these growth rates are among the lowest in the last 50 years.
"On the flip side, equity market gains are among the best in the last 50 years. As the stock market approaches year-end, the S&P 500 is due to log one of the best five-year average annual performances since 1950. If the market closes near recent highs, the five-year average annual growth rate of 14.8% ranks in the top 10 with only four periods in the late '90s and two in the '50s besting the performance. However when measuring against the same five-year average annual economic growth rate of 2.4% the performance of the market is number one over the time frame."
These five-year periods in the late '90s and '50s that bested the past five-year returns were all in the right tail of 10-year periods, so there is no doubt that this equity market is working on a historic performance. As I point out, though, when measured against economic performance, it is the best in the last 60 years. The question is whether it can continue. What are your 10-year average annual returns going to be at this time in 2018? The market performance relative to nominal growth is relevant. Corporate revenues essentially grow at the rate of nominal GDP, thus any performance in excess of this growth rate is largely due to multiple expansion. This year’s market return which has largely been a function of multiple expansion is a perfect example. But over time you can’t solely rely on the multiple to generate returns. At some point you will need economic performance to share the burden of returns. Thus you can’t simply measure historical market performance without regard to economic growth.
I went back to measure the S&P 500’s 10-year annualized performance relative to average year-over-year nominal GDP growth beginning in 1955 and found remarkable consistency. I omitted negative 10-year market return in the 1970s, 1980s, and 2000s to get a better sense of bull market performance relative to growth and found that both the median and average ratio of market returns to be 1.5x relative to nominal GDP growth. In fact the largest ratio was only 2.8x in 1998 and 1999 when annualized market returns were 16% and 15% respectively against 5.7% and 5.5% nominal GDP.
To get an idea of how torrid the market performance of the past five years has been, you only need to look at historical 10-year annualized performance relative to economic growth. This current blistering pace is not sustainable, and if a reversion to the mean is to take place over the next five years, returns are going to suffer.
Using historical growth rate ratios we can come up with a range of 10-year returns relative to nominal GDP and thus come up with probable values for the S&P 500 in December 2018. Keep in mind these assumptions are cyclical bull market ratios to growth.
In the most optimistic scenario of right tail 10-year annual returns I use a ratio of 2.3x nominal GDP that accompanied average annual market growth rates of 15%, 16%, and 17%. Using a very optimistic 4.0% average nominal GDP growth rate, which would require a major acceleration in growth from the current 3.0% pace, and applying a 2.3x multiple, yields a 10-year annualized return of 9.2% -- or an S&P 500 price level of 2100 by December 2018.
Under a more pessimistic but realistic scenario, you could assume the current 3.0% nominal GDP growth rate continues over the next five years and apply the average bull market 1.5x ratio to growth which would yield a 4.5% 10-year annualized return for an S&P 500 price of 1350 in December 2018.
After the 1982 stock market low, the 10-year annualized performance by 1992 was 12% at 1.7x the average nominal GDP growth rate of 6.9%. If you simply use this ratio ratio relative to current 3.0% nominal GDP you only get a 5.1% 10-year annualized return, which puts the S&P 500 at 1450 by December 2018.
Giving the benefit of the doubt, and assuming an optimistic 3.5% nominal GDP growth rate and the 1990s average market performance ratio of 2x, you still only get 10-year annualized returns of 7%, which puts the S&P at 1725 in December 2018, right smack-dab in the middle of the historical distribution.
Needless to say, when you do the math, the numbers are discouraging. The market is eventually going to revert to its longer-term average annualized return relative to growth, and that likely means the historic performance of the past five years is going to be smoothed out over the next five years. Under a wildly optimistic scenario, you are looking at a potential 16.7% total return from these levels. Under a more pessimistic scenario, you could see a 25% decline. If everything goes right, you might be around breakeven or only down 4%.
You can’t measure the 15% annualized return in a vacuum without regard to the growth rate that accompanied it. When measuring this rally against history it becomes obvious that the parabolic move off the 2011 low has pulled forward a substantial amount of return that would have been provided over the next five years if not longer. Is it a bubble? I don’t know and I don’t care. I only want to know what my equities are going to be worth in the future. Barring some unforeseen pickup in nominal growth, the odds are that at this time in 2018, the S&P 500 will be worth virtually the same or less than it is today. Does that mean sell? No, but you need to lower your expectations and be prepared to take advantage that these poor returns will provide you.