From an investment standpoint, it is similarly evident that investors have adopted a renewed willingness to speculate in recent weeks. I use the word “speculate” because on a valuation basis, we estimate prospective 10-year total nominal returns for the S&P 500 of just 4.7% annually (probably much less after inflation, as we expect increasing price pressures in the back half of this decade).
This 4.7% 10-year annual total return estimate would be less of a concern if our valuation methodology was less accurate historically. The exception to this record of accuracy was the much stronger-than-expected market performance in the decade from 1990 to 2000, associated with the late-1990’s bubble, but even this was essentially an exception that proves the rule, as total returns since the late-1990’s have been predictably dismal, as has the most recent 10-year total return from January 2002 to the present. I am not convinced that the dynamics of the U.S. economy have improved so dramatically since 2002 that our approach to market valuation – accurate both historically and as recently as the past decade – has suddenly lost its relevance.
[For an overview of our valuation approach, see Valuing the S&P 500 Using Forward Operating Earnings ,The S&P 500 as a Stream of Payments , or numerous prior comments. For more on Wall Street’s misuse of forward operating earnings, which is as rampant and naive as it is ineffective, see Long Term Evidence on the Fed Model and Forward Operating PE Ratios ].
Notably, our projections for 10-year S&P 500 annual total returns advanced above 10% at the 2009 market low. Anyone new to these weekly comments can fairly ask why we missed that opportunity by remaining defensive. It’s worth repeating that our avoidance of risk in 2009 and early 2010 was driven by my insistence to “first do no harm” by stress-testing our hedging approach in Depression-era data and other periods of extreme credit strains. The problem in Depression-era data is that even once 10-year prospective returns reached 10%, the market actually declined by two-thirds from there. While our existing “post-war” models performed well overall in that data, with far less drawdown than a buy-and-hold approach, they still would have experienced much deeper drawdowns than I was willing to allow shareholders to risk. Once we were forced to contemplate the possibility of Depression-era outcomes, I insisted that our methods should withstand that level of stress.
Having adapted our hedging approach to a much broader set of data, we are less concerned about the potential for extreme economic outcomes that are “out of sample.” At the same time, a material improvement in valuations should give us much broader ability to invest without defensive hedges in place.