Below, I’ve annotated our usual valuation chart to provide a better sense of what drives the long “secular” movements in the stock market. The chart uses our standard valuation methodology to estimate prospective market returns.
It should be quickly evident that secular bull markets don’t simply come out of the blue. They emerge precisely because stocks become priced to achieve extraordinarily high long-term returns. Both the 1947-1965 secular bull and the 1982-2000 secular bull began at points where stocks were priced to achieve 10-year returns of close to 20% annually. In contrast, the 1965-1982 secular bear began with prospective 10-year returns of just 5.9% (though slightly higher than the 4.4% yield on Treasury bonds at the time), and of course, the secular bear that began in 2000 emerged from bubble valuations, where we projected negative 10-year total returns at the time.
It seems to be an article of faith among some analysts that the 2009 low represented the start of a newsecular bull market, but two features are noteworthy. The first is that the valuation achieved in 2009 was nowhere near the valuation that typically ushers in a new secular bull market. The second is that the brief undervaluation we observed in 2009 was quickly eliminated. At present, we project total returns for the S&P 500 of just over 4% annually over the coming decade. This is even worse than the valuation where the 1965-1982 secular bear started (though certainly less extreme than the 2000 peak). Though interest rates are lower today than in the 1965-1982 period, satisfactory returns from present levels will require investors to sustain rich valuations indefinitely.
Again, it’s worth emphasizing that our standard valuation methods are (and have remained) well-correlated with subsequent market returns – a very basic criterion that is painfully lacking among many popular valuation measures such as the Fed Model. It strikes me as absolutely bizarre that so many Wall Street “professionals” offer up the Fed Model and the “forward operating earnings times arbitrary multiple” approach so freely, when it takes nothing but some data and a few hours of effort to demonstrate that those approaches are nearly worthless (see for example the August 20, 2007 comment Long Term Evidence on the Fed Model and Forward Operating P/E Ratios - not that many analysts agreed with our valuation concerns at that point either).