Dismal Prospective Returns

The S&P500 crawled up about 1% last week on abysmally low summer volume. At the same time, volatility dropped back down to near record-low levels as investors once again seem to have dismissed the risks that stock market, near its all-time highs, could possible decline—meaningfully—from here. Corporate sales are falling. Corporate profits are weakening. And the US economy is stalling. Yet the US stock markets keep on chugging along, as though nothing could possibly stop corporate profits—still near record high levels when compared to sales or GDP—from growing even more.

Yet in other markets, the picture was not so optimistic. Treasuries sold off again for the week. So did investment grade corporate bonds, as well as high yield, or junk, bonds. These markets, combined with their derivatives markets, are far larger than the combined US stock markets. And these markets are expressing a bearish message. One of these two camps is wrong—either the stock market is too high and will come down to meet the larger credit markets, or the credit markets are wrong and will go back up to meet the exuberant stock market. History shows, over and over again, that the credit markets are almost always right.

The US economy is still limping along, struggling to gain traction fully four years after entering its so-called ‘recovery’ in mid-2009. Last week, pending home sales missed. The Dallas Fed manufacturing survey missed. Consumer confidence missed. Chicago PMI missed. And construction spending missed. The first estimate for Q2 GDP growth beat expectations, but only after the first quarter GDP growth was slashed almost in half. And still, even with the Q2 beat, growth is anemic. Initial jobless claims beat expectations as did ISM manufacturing. However, the big number of the week, payrolls, was a big miss, on several fronts. First the headline jobs number, at 162K, came in lower than the expected 175K. Then the workweek fell below consensus estimates. Next, average hourly earnings plunged; instead of rising 0.2%, the fell 0.1%. Finally, the labor force participation rate dropped, which means that even more would-be workers are so discouraged by hiring prospects that they’re simply leaving the workforce and are no longer even counted as being unemployed by the Bureau of Labor Statistics.

Technically, the S&P500 is extremely stretched. On multiple technical measures, the stock market is grinding along at highly overbought levels. which means that millions of investors are comfortable riding this wave all believing that they’ll have no problems exiting the party, or the market, at the first sign of trouble.

John Hussman, long time money manager, in his weekly comments points out that as the stock market grinds ever higher, returns in the future will by definition continue to creep lower. And today, the US stock market is priced to return only 2.8% per year for the next ten years, with severe price volatility to be expected in the interim. This is the lowest 10 year prospective return since the tech bubble highs in 2000.

He measures this prospective return several ways. He first notes valuation using the Shiller PE, and today at 24, the stock market is far over his 18 threshold for being over-valued. He also judges whether the market is over-bought, which is primarily dome by looking at Bollinger bands at the daily, weekly and monthly resolutions; and yes the stock markets are over-bought. He then looks at bullish sentiment by comparing the bullish vs. bearish sentiment of investment advisors, and yes, the stock market is overly bullish. Finally, he assesses whether the US 10 year Treasury yield is rising when compared to its yield from six months earlier; and yes, this too is happening.

But the worst part is not the measly 2.8% prospective yield over ten years (which by the way, Hussman has been estimating with 90% accuracy for several decades). The worst part is the intervening price volatility, which means that even though the 2.8% annual yield may be achieved, the market conditions—as outlined above—are almost always associated with intervening price drops over 40% or more.

So the question is, if you’re buying into the stock market now (or just deciding to hold on to what you have), are you really prepared—emotionally—for the strong possibility of massive, yet temporary, price drops along the way, over the next ten years?

What we learned in 2000-2002 and again in 2007-2009 is that while most investors say they are ‘buy and hold investors’, very few actually have the stomach not to sell out near the lows, much less put new money to work at the lows. Instead, most people—professionals and retail alike—tend to sell near the lows, locking in losses, and therefore never actually realizing their former paper gains.

This challenge is once again facing investors in the US stock market today. And once again, good luck with the ‘holding’ part of the investment strategy.

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