For pretty much all of 2020, I have been offering somber and cautious warnings about the dangers one implicitly accepts when investing in markets with valuations as high as they are currently. I have been particularly concerned about the U.S. market as represented by the S&P 500 and by the metric of the (Shiller) CAPE (Cyclically Adjusted Price Earnings) ratio, which currently stands at around 32 – about double the historical average.
Over the years, I have encountered people who dismiss the works of academics like professor Shiller by insisting that they take their cues from actual practitioners – people like Warren Buffett. Just as Shiller is best known for CAPE, Buffett has often said that the single most reliable metric he has found regarding broad market valuations is the Market Cap to GDP ratio. Over the years, this ratio has become known to many as the “Buffett Ratio”. As of the end of August, it stood at 184.5%. In short, the U.S. stock market is very significantly overvalued. The consensus is that anything over 135% is significantly overvalued. I simply added the word “very” to underscore how extreme the current reading really is.
Let’s try to put this in context by looking at data from both sides of the border. Both Canada and the U.S. have seen strong rebounds from the market lows reached in March of this year. In particular, the American market is now hitting new all-time highs. That’s the Market Cap (stock price times total number of shares outstanding) part. Now for the GDP. The gross domestic product for both economies dropped by about a third in early 2020. In fact, the Canadian GDP plummeted 38.7% in Q2 alone.
The result has been a remarkably swift decoupling, which could have catastrophic consequences down the road. To the best of my knowledge, there have only been a couple of instances in all recorded history where markets went up by 50% in the span of four months or so. There have also only been a couple of instances where GDP has dropped by more than a third over a similar timeframe. However, there has never been an instance where both those two trends occurred concurrently.
I say to you again: this cannot stand. Some time, some way, this must end – and it will almost surely end very badly. The entire financial services industry, however, seems determined to remain optimistic to the point of deluded denial about things that are self-evident and patently obvious. The industry diverts investor attention toward good news when important indicators like the one used by one of the great value investors of all time doesn’t suit their narrative. I call it “Bullshift”.
We are very likely heading for a period of prolonged weak returns. This includes a somewhat less prolonged front end that will almost certainly entail negative returns. What follows is not a prediction, but an exercise in self-examination. No one knows for sure what the future holds.
With that said, if someone told you today that the expected annualized return for stocks over the coming decade was negative and the expected return for stocks in the decade after that was only (say) 7%? What if that average annualized return over the next generation was only about 3%? I don’t know what’s in store, but I strongly suspect that the scenario depicted in my hypothetical questions is likely to be more reflective of what we experience than what’s in your financial plans currently.
The cost of both investment products and financial advice is about to become exceedingly consequential. It seems the entire financial services industry is in denial about an existential crisis of its own making. Having convinced everyone, including themselves, of inexorable long-term gains, the industry seems ill-equipped to acknowledge the limitations and risks of that mindset.