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'Is This a Stock Market Bubble?' Is the Wrong Question to Ask

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The real issue here is what this historic rally portends for future returns.

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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.

Twitter: @exantefactor
No positions in stocks mentioned.
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