Today’s Stock Valuations Will Drive Future Returns

Once again, in spite of many economic and global-macro concerns, the S&P500 powered forward with a 1.6% gain last week. In the process, it set new all-time high records.

Volume, while still low, did move higher. And volatility, as expected, backed down….close but not all the way back down to the multi-year lows reached in the summer.

As mentioned, US economic news took a turn for the worse last week. Producer prices came in much lower than expected—this is usually a sign of weaker than expected industrial production. Jobless claims were still high, in part due to the flooding in Texas several weeks ago. Retail sales were a disaster—both headline and core results missed by a mile. Industrial production plunged…also very bad. And consumer sentiment missed expectations. All in all, the US economy took a turn for the worse last week.

In terms of technical analysis, the daily charts show a stock market that’s stretched to the sky—prices are once again hugging the upper Bollinger bands. On the weekly charts, interestingly however, the bearish momentum signal that appeared several months ago has not been erased by last week’s gains. And since most technicians put greater weight on longer terms charts (over shorter term charts), this continued bearish signal bears watching.

While all-time highs—in prices—have just been set again, it’s important to remember that when valuations (as opposed to prices) reach all time highs, future returns will be lower than the returns achieved prior to the time that valuations peak. Simply put, record high valuations today, always lead to much lower returns tomorrow. But are valuations stretched today? Absolutely, and many blue chip firms on Wall Street are agreeing with this assessment. For example, the Shiller PE of the S&P500 is now as high as it was in 1929, just before the crash, and exceeded only at the peak of the dot-com bubble. In other words, this very important measure of market valuation has been higher only one time in the last 100 years!

The mistake that almost all investors are making is simple….and always made near market highs—they erroneously assume that gains in valuations leading up to big stock price moves will repeat in the future. They completely ignore the fact that market history shows that the exact opposite happens—that market valuations are mean-reverting. So while investors are enjoying today’s bubble valuations, almost all these investors will end up giving back their big gains because they will fail to sell near these valuations; instead, they will ride the equity markets down, to more historically normal valuations, all the while lamenting that “nobody saw it coming”.

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