Average Returns are Expected with Stocks at Fair Value

13 Oct

The capital markets and the economy are related, but exhibit disparate behavior. The U.S. economy has not been performing well since March, but that hasn’t stopped the stock market from rallying nearly 60% from the lows. The market rally has not been limited to stocks. Indeed, risk aversion has meaningfully subsided across the capital markets; the least creditworthy stocks and bonds have led the charge higher. High yield bonds are up nearly 50% this year, more than double the S&P 500. These risky bonds now yield less than 8%, close to where very low risk (AA) bond yields peaked early this year. Triple-C bonds, which are “currently vulnerable and dependent on economic conditions to meet [their] commitments,” are up 92% for the year. It appears to us that from current capital market valuations, further (durable) price appreciation will require fundamental economic improvement.

We never know where the markets will move next, but we can make reasonable estimates of their intrinsic value. According to our estimates, the S&P 500 trades at 16 times normal earnings and near the high end of its value range. Using cyclically adjusted earnings for the S&P 500, stocks trade at closer to 20 times. (The price-earnings ratio for the market has averaged roughly 15 over very long periods.) Another measure of market valuation which focuses on the replacement value of assets, is over 0.80, just slightly above the long-term average of roughly 0.75. One measure taken alone may not indicate much, but several arrows pointing in the same direction demand more attention. And on many different measures, the domestic stock market in aggregate is no longer cheap but fairly valued.

Ultimately, investors should be rewarded for providing capital to those who use it. But contrary to popular belief, risk and return do not always follow a linear relationship; that is, high risk does not necessarily equate to a high return. Today, the capital markets appear much riskier than just a few months ago (at lower prices) and implied long-term future capital market returns appear to be merely average from today’s levels. What that means for the near-term direction of markets is anyone’s guess.


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