Back in January, I wrote that U.S. stocks were priced to deliver returns of about 0.3% per year over the next eight years.
Well, thanks to the monster rally we saw in February, U.S. stocks are now priced to deliver returns of negative 0.3% over the next eight years.
This negative forecast is based on the current reading of the Cyclically Adjusted PE Ratio (CAPE), which now sits at a very bubbly 27 — about 63% higher than the long-term average of 16.6. Take a look:
How the CAPE differs from the traditional P/E ratio is that it divides the stock price by the average earnings over the past 10 years, as a way of smoothing out the booms and busts of the business cycle that can temporarily inflate earnings.
Research site GuruFocus calculates the CAPE and then forecasts returns for the next eight years by considering three variables:
- Dividend yield
- Economic growth (average growth rate of the past 8 years)
- Expansion or contraction of the CAPE to its historical mean
Today, the market’s dividend yield is very modest at 1.9%, and economic growth has been tepid at best. Even ignoring the recession years, real GDP growth has averaged only 2% to 3% over the past eight years.
Now, let’s be clear: Any notion that 27 becomes the CAPE’s new normal is wildly unrealistic. So, let’s take the CAPE forecast at face value and assume that valuations eventually return to their averages. This gets us annual yields that are basically flat over the next eight years.
You may be thinking: “Flat? I can live with that.” No… you can’t.
Markets don’t just stop moving for eight years at a time. Just because The S&P 500’s value was essentially unchanged between 1999 and 2007, that didn’t mean the market moved sideways for that eight-year stretch. Rather, it lost half its value before eventually finding a bottom.
As Harry explained today, we’re set for a huge market correction. Don’t just stick to your guns and commit to a buy-and-hold strategy. If you’re in this market, you’ve got to stay tactical. Don’t be afraid to sell and take a little risk off the table.
Better buying opportunities will come. They certainly did after both the 2000 and 2007 tops. In the meantime, be careful — we’re in for a rough patch ahead.
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