Here’s Why Investors Are Now Facing Another “Lost Decade” In The Stock Market

In my last piece, I wrote that stock market valuations are currently at the same level they were when Warren Buffett, in November 1999, wrote his famous op-ed for Fortune magazine explaining that investors would inevitably be disappointed by returns over the coming decade. The stock market actually declined 30% over the following 10 years. “Disappointed” was actually an understatement as investors were downright despondent (which set up a wonderful opportunity to be greedy).

In fact, when looking at median valuations in today’s market, stocks are even more overvalued than they were at the peak of the internet bubble, some 3 or 4 months after Buffett’s piece was published. Considering valuations are roughly equivalent, or even worse than back then, what are the odds that we see another “lost decade”?

This is actually fairly easy to answer. The valuation indicator we looked at in the last post, total stock market capitalization in relation to Gross National Product, has actually been 83% negatively correlated to future 10-year returns dating back to 1950 (high valuations mean low forward returns and vice versa). Based on this correlation, this measurement of valuations, Buffett’s favorite, currently forecasts an annual return over the coming decade of about -0.88%. Yes, that’s losing almost 1% per year over the next decade – the very definition of a lost decade, even if it’s not quite as bad as the 1999-2009 period.

Screen Shot 2015-01-26 at 2.30.37 PM

Now there certainly is a possibility that stocks do significantly better than that dour forecast but it’s not very likely, at least not from a historically-informed perspective. (I should note here that other measures that are very highly correlated to future returns essentially agree with this one, as well.) This is why some of the most respected firms in the world, like GMO and Bridgewater, are informing clients of this very same fact.

And if I were forced to take the over/under on a 0% forecast over the next decade I would take the “under” for one simple but significant reason. The decade following Buffett’s op-ed saw stocks decline 30% but the Fed recently published research suggesting the decline from today’s level could be even greater than that simply due to demographics. Their study implied a decline of closer to 40% was very possible, if not probable.

The thesis suggests that equity valuations will be under pressure until 2025 as baby boomers age and reduce exposure to risk assets. Intuitively, this makes sense. During their peak earning years, the baby boomers poured money into the stock market driving the greatest equity bubble in history. As they now enter their later years the demand for equities, or lack their of, from this generation could have the opposite effect.

A chart from Ned Davis, in his terrific book “Being Right Or Making Money,” shows that this is not just theory. The chart below plots equities alongside births in the United States shifted forward 46 years (to the beginning of peak earning age). Clearly, over the long-term, equities benefit or suffer based simply on the general demand from the relative size of a given generation. Demand, as evidenced by births, has been waning since 2005. Another plunge in births begins right about now and looks to bottom sometime after 2020 before picking up again in 2025.


At best, equity returns over the coming decade will simply reflect earnings growth, assuming valuations can remain elevated. Historically, this has averaged about 3.8% over time. At worst, valuations will revert to an undervalued state and stocks will decline about 40% or more, as the Fed study suggests. Either way, the odds for another “lost decade” in the stock market are far higher than most people currently believe.


The Single Greatest Mistake Investors Make

The single greatest mistake investors make is to extrapolate recent history out into the future. They take the financial returns of the past 5 days or 5 years or even 50 years and assume the next few days or years will look just the same without any consideration for the historical context or conditions that provided for those returns.

They forget that, while ‘history may rhyme, it doesn’t repeat itself’ (Twain). Or that, “the only thing that is constant is change” (Heraclitus). These two famous quotes apply to the financial markets as much as anything.

Ignoring these truths and instead simply extrapolating is why investors are suckered into pouring money into the stock market only after a run of great performance. They believe that the recent gains are about to repeat to their great benefit when they should be thinking about what conditions allowed for those gains to take place and analyzing whether they are still relevant or not.

This is also why they are suckered into selling only after a painful decline as they did at the lows made during the financial crisis. They believe that they are about to suffer another 50% decline on top of the one they just endured when they should really be reminding themselves that change is the only guarantee in life.

I believe this is one of the biggest problems with so-called “passive” investing. It is built upon the faulty premise that it is ‘impossible to forecast’ the future returns of any asset class over any period of time so we should just own all of them all the time. My response to this is that while ‘ignorance may be bliss’ it’s not a valid investment strategy.

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffett wrote:

We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. However, it is clear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and that fact makes us quite confident of our forecast that the rewards from investing in stocks over the next decade will be significantly smaller than they were in the last.

Much can be learned from this short passage. First, short-term stock market forecasts are, indeed, nearly worthless – essentially a guessing game. Second, long-term forecasts, on the other hand, can be made with ‘confidence.’ “How?” you ask.

It’s actually very simple. Rather than fixate on recent history and extrapolate it into the future you must abandon this natural tendency. And as I said earlier you also need to analyze the conditions that allowed for those returns to see whether they are still relevant to today’s market.

In Buffett’s example he’s referring to the wonderful returns equity investors experienced from 1982-1992. During that span investors roughly quadrupled their money. Over the coming decade they merely doubled their money so Buffett was right that the decade beginning in 1993 would fall far short of the return of the prior decade even it they were still very good.


But Buffett made another prescient forecast in November 1999 when he wrote:

Today, staring fixedly back at the road they just traveled, most investors have rosy expectations. A Paine Webber and Gallup Organization survey released in July shows that the least experienced investors–those who have invested for less than five years–expect annual returns over the next ten years of 22.6%. Even those who have invested for more than 20 years are expecting 12.9%. Now, I’d like to argue that we can’t come even remotely close to that 12.9%… you need to remember that future returns are always affected by current valuations and give some thought to what you’re getting for your money in the stock market right now.

You probably already know that stock market returns from 1999 to 2009 were not very kind to investors.


And Buffett tells us how he was so confident that this would be the case. He examined the conditions that allowed for returns to be so wonderful from 1982-1999 but were no longer present in 1999: wonderful valuations. Stocks were so cheap in 1982 that the coming decade was virtually guaranteed to be better than the decade that preceded it. (1972-1982 was another decade that was not fun for investors.) Then in 1999 valuations were so expensive that there was almost no possibility of decent returns going forward.

So let’s take a look at Buffett’s favorite valuation yardstick which he refers to on both of those prior writings. It tracks the total value of the stock market in relation to Gross National Product.


From the chart, it’s plain to see that valuations were extremely attractive back in the early 1980’s. This is why stocks performed so well over the next 20 years. However, I find it absolutely fascinating that stock market valuations today are essentially equivalent to valuations in November 1999 when he wrote that latter passage. Yeah, go back and read that last line again. It’s a doozy and it’s absolutely fact.

This is also why the past 5 years or even the past 50 years are totally irrelevant to equity investors in today’s market. There is almost zero possibility today of achieving a return anywhere close to what those historical returns represent. So shun forecasts if you want. Plead ignorance if it makes you feel blissful. But at today’s valuations you should at least be aware of the fact that it’s exceedingly dangerous to fall into the trap of extrapolating without analyzing.


The Skyscraper Index Is Flashing Another Sell Signal

STOP! Before you flood my inbox telling me I’m an idiot to put any faith in such a stupid concept, know that this is just for fun. This is not anything to be relied on for any reason, unless you’re just curious about these things, as I am.

Now that I’ve gotten that out of the way, I find it fascinating that at this point in the business cycle we are once again witnessing a race to build a record-breaking skyscraper. The “Skyscraper Index” is a concept that suggests, “the world’s tallest buildings have risen on the eve of economic downturns.” Statistically speaking it may not be entirely accurate but I find the theme to be very intriguing nonetheless.

Although the index was only created in 1999, this concept dates back to time immemorial. In fact, the tower of babel should probably be the first instance catalogued by the index. In short, humans built a tower to the sky to celebrate their god-like powers (of uniting humanity under one language) and were soundly smote in response. This story can be found in many religions, actually. And ever since there have been many great monuments built during times of economic euphoria as a testament to our greatness. Only shortly thereafter do we realize it was not so much greatness as hubris.

Construction of record-breakers like the Singer Building and the MetLife Building coincided with the panic of 1907. The Empire State Building, the Chrysler Building and 40 Wall Street, were all built or launched just prior to the 1929 stock market crash and subsequent Great Depression. The World Trade Center and the Sears Tower opened just prior to the 1973-74 bear market. Today, we have two New York developers racing to build the tallest residential building in the Northern Hemisphere.

So where are we in the business cycle? I have no idea. Over the course of modern history, however, our economy has suffered a recession every five years or so. The last recession ended June of 2009, just over five years ago. (In and of itself, this does not suggest we are necessarily due for a recession but global growth is clearly slowing and I doubt the US will be entirely immune.) The longest expansions in American history lasted about ten years. It may be fair to say, then, that we are probably closer to the end than the beginning of this particular expansion. And regular readers should know where I believe we are in the financial market cycle.

Late in the economic cycle, then, in the financial capitol of the world, which has benefitted mightily from the greatest money-printing experiment in the history of the world, we have two real estate developers in a heated battle to build a greater testament to their own greatness than the next guy. To my mind, it is the height of financial hubris and a clear example of economic euphoria. And it’s all happening just as luxury apartment sales in New York are starting to slow. All in all, I wouldn’t be surprised to see this index correlate with yet another economic and financial market peak.


Has Demand For Stocks Dried Up?

We all spend a great deal of time analyzing valuations, technical patterns and sentiment in trying to determine if it’s a good time or bad time to buy or sell. I try to constantly tell myself, “keep it simple, stupid.” In that vein, there’s a much easier way of looking at the markets even if it means taking a very long-term view.

My friend @jesse_livermore recently wrote a terrific piece about the ultimate arbiter of market prices: supply and demand (go read it). This basic economic principle applies just as much to the financial markets as it does other prices. In fact, you can make a great case that the Fed limiting supply of Treasuries over the past few years has been a major factor in their incredible surge.

By the same token, there’s one chart that has stuck in my mind over the past year or so since it peaked. And that is the chart of total margin debt – more specifically, the chart of net credit balances in brokerage accounts:

NYSE-investor-credit-SPX-since-1980Chart via Doug Short

As you can see, we are currently witnessing the largest negative balance in brokerage accounts on record (second-most ever relative to GDP). Looking back over the past couple of decades it’s plain to see that stock prices have either benefitted or suffered from ebbs and flows in supply (stock for sale) and demand (stock for purchase).

The runup during the internet bubble benefitted from a massive amount of demand for equities fueled by rapidly expanding margin debt. Stocks peaked due, in some degree, to investors maxing out their ability to borrow and demand essentially dried up. Eventually, those shares they acquired during the bubble became supply and there was no new source of demand to soak it up. Prices were roughly cut in half.

Conversely, after the financial crisis, all the excess cash in brokerage accounts was converted to demand for equities which fueled the boom in prices during the beginning of the bull market. Then investors began to borrow and the growing margin debt once again pushed prices higher still. Now here we sit with record negative balances in brokerage accounts.

The simplest conclusion we can draw from the current levels of negative balances then is that there is currently record low potential demand for equities. In other words, the fuel for higher prices is running dry, if it hasn’t already (as I mentioned earlier margin debt levels peaked almost a year ago). Long term investors would do well to make a note of this and consider it in their long-term plans.

In the shorter-term, though, it’s probably worth noting that, on the flip side, there is also “record potential supply” for equities which can cause problems all on its own. Just take a look at what has happened recently to the price of oil. Massive new supply comes online (from the shale boom) and the price collapses about 60% in only 6 months time.

Now, I’m not saying the stock market will collapse. I’m just saying that should this potential “supply” come to market it could make for some very turbulent trading. (Another component of growing supply for equities comes from the IPO market, which last year nearly matched the record set in 2000.) And the potential for “demand” to save the day is very limited, at best.


The Stock Market Is Just Noticing What The Bond Market Has Known For Months

…that growth is slowing, the credit cycle could have already peaked and risk appetites are waning.

Over the summer I attended a conference which featured Steen Jakobsen as one of the speakers. The one thing he said that really stuck with me is that long-term bond yields lead the economy by about 9 months. If that is true, economists are going to be dramatically lowering their expectations for growth over the coming 9 months as the 10-year treasury has seen its yield plummet over the past year (not to mention foreign yields which are now negative at maturities of up to 5 years):


What’s more, the yield curve (the difference between the 10-year and the 2-year treasury yield) has flattened almost back to the level it saw at the very bottom of the financial crisis:


For most of 2014, stocks completely ignored this warning from the treasury market of slowing growth. One asset class that hasn’t ignored it is the corporate bond market, specifically the riskiest sector of the corporate bond market. High-yield bonds have been sending a clear signal for months now that, after a long hiatus, risk is making a comeback and the long-benign credit markets may be shifting to something not so benign. In his conference call yesterday, Jeff Gundlach called this divergence between stocks and high-yield, ‘the most worrying signal coming out of the markets right now.’


Most equity bulls have written off the weakness in junk bonds as a reaction to the oil crash which they believe will be contained. Junk has anywhere from 14-18% exposure to energy. However, leveraged loans have only a 4% exposure to energy and they have been just as weak, if not weaker, than junk bonds. This tells me that this growing risk aversion goes beyond just the energy sector and has implications for all risk assets, including stocks.

I guess nobody told the stock market as much until very recently. For the past few years risk appetites in the bond market (willingness to venture out on the risk curve from treasuries to riskier fixed income instruments) have been very highly correlated with stock prices – I’m talking 98% correlated… until last summer, that is. Since then, virtually all other risk assets have declined while US stocks continued to make new highs.

Screen Shot 2015-01-14 at 7.34.48 AMSo to my mind the stock market weakness over the past couple of weeks is merely a function of equities playing catch up with all other risk assets. Stocks are just starting to pay attention to these messages of slowing growth, increasing risk and waning appetites.

In the short term, my model suggests the S&P 500 should be trading closer to 1800 than 2000, based solely on bond market risk appetites which, as I said, have been very highly correlated in the past. Having said that, bond market risk appetites are a moving target. They could recover and that would change this forecast. But should we be witnessing a cyclical end to the incredible hunger for risk assets we’ve seen over the past few years (inspired by ZIRP and QE) then I imagine this is only the beginning of the process. Yield spreads certainly have plenty of room to move wider still. We’ll just have to keep our eyes peeled, I guess. And keep them trained on the bond market which will likely tell the tale.


By Some Measures This Is The Most Overvalued Stock Market Of All Time

Not so long ago I wrote, “this is probably the second worst time to own stocks in history.” However, when you look at the market a bit differently you can make the case that this could be THE worst time ever to own stocks.

Most broad valuation measures are market capitalization-weighted simply because the major indexes are cap-weighted. The S&P 500, for example, currently trades at a price-to-earnings ratio of about 19. However, the p/e of the Russell 2000 small cap index is closer to 80!

Screen Shot 2015-01-13 at 9.28.35 AMChart via wsj.com

This disparity between the two is hidden from the valuation discussion most of the time because it usually focuses on the stock market as represented by the largest 500 companies. When you look at the broader market, though, it’s clear there’s much more to the story.

So how do we reconcile the small cap p/e that is off the charts with a large cap p/e that is elevated but not nearly as ridiculous? Looking at the median p/e (the valuation of the company in the exact middle of the pack) should do the trick. Fortunately, Jim Paulsen of Wells Capital has already gone to the trouble of putting this together:

Screen Shot 2015-01-13 at 9.32.03 AMChart via wellscap.com

There you have it: the most overvalued stock market of all time, based on median price-to-earnings. (For what it’s worth, Paulsen also demonstrates in the paper that on a price-to-cash flow basis stocks have also never been as highly priced as they are today.)

Here’s what I think you should take away from this. The first thing I think about when I see a chart like this is my potential reward versus the potential risk I’m assuming. The best possible situation would be for valuations to remain elevated for the foreseeable future. Then my gains should be roughly equivalent to corporate earnings growth, probably in the low to mid-single digits. However, in a worst case scenario, valuations return to the bargain bin and I’m facing steep losses (possibly 50% or more). All in all, I’m risking half my capital to make a single digit return.

The second thing I think about when looking at the chart above is my long-term rate of return is determined by the price I pay. If I’m fortunate enough to get a below-average price then over time I can reasonably expect an above-average return from stocks (10% per year or more). Pay a high price and I guarantee myself a mediocre return. Pay a record-high price and I’m essentially locking in one of the worst long-term returns in history (probably somewhere close to 0%).

Now I have to say that I believe price-to-earnings ratios are not the best way to value individual stocks or the broader market. There are other methods that are much more valuable for forecasting long-term returns like Warren Buffett’s favorite yardstick, total market cap-to-GNP. See “everything but the US stock market has already peaked” for my latest update on it and other indicators crucial to long-term equity performance.


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