The following is a summary of our recent FS Insider podcast, “Ed Easterling on Market Valuations, Expected Returns, and Flawed Assumptions,” which can be accessed on our site here or on iTunes here.

Right now, many investors are concerned about US stock market valuations…and for good reason. If we look at Doug Short’s average of the four valuation indicators below, it shows that the S&P 500 is now the second most expensive going back to 1900, overtaking the 1929 peak but still behind the insanely overvalued 2000 tech bubble.

stock market bubbles
Source: Advisor Perspectives, annotations not included

Because of this, Ed Easterling at Crestmont Research says that stock market returns are likely to be very low over the next 10 years and, even more importantly, that many in the financial community (robo-advisors included) make a profound error by using the long-term historical average of 10% for stock market returns without considering where we are in the current market cycle.

Here is one of our favorite clips from yesterday’s interview where he explains this in terms of taking a vacation to Chicago:

Today’s Market in “Range of Vulnerability”

After breaking down current dividend yields, earnings, and PE multiples, Easterling noted that the US stock market is well above its fair value range but didn’t think it could quite yet be characterized as a bubble.

The fair value range associated with low inflation would typically be in the low to mid-20s in terms of the price-to-earnings ratio, and right now we’re in the high 20s. We’re probably 10 to 20% above the fair value range, so this market isn’t grossly overvalued, but modestly overvalued, Easterling noted, and certainly in the range of vulnerability.

“Going forward, I would expect from this level of valuation that we have a very little contribution on the upside, and maybe some to the downside, from the price-earnings ratio,” he said.

What Does This Mean for the Next Decade?

There are three components to stock market returns, Easterling noted: earnings growth, dividend yield, and the change in the valuation level or the change in PE.

If we assume low levels of inflation, that means we should expect “about a 6% compounded annual return over the next decade,” Easterling said. “That’s what I would call a bear in hibernation.”

Keep in mind, this 6% rate is nominal, and doesn’t account for inflation eating away a portion of this growth. Once you account for inflation then, real stock market returns over the next decade will likely be in the low single digits.

But what would happen under a higher inflation scenario?

“Although we would get a little extra benefit to the earnings growth, that multiplier effect of that PE coming down more than offsets that, and (we’d be) in a rising inflation environment with returns over the next decade being close to zero,” he said.

Investors Will Never Experience the Long-Term Average

The assumptions that relate to 100-year returns don’t relate to 10-year outlooks, and certainly not in the current environment, Easterling noted.

If we look back at every decade–long period since 1900, the average return was 10%, but no decade was exactly 10%. If we consider everything between 8 and 12% to be average, in that case, decade-long averages fall outside of the normal range around 80% of the time.

“The reason that’s important is because the odds-on bet is either another decade of above-average (above 12%) returns or below-average (below 8%) returns,” Easterling said. “But one thing that the above-average returns group has in common, is they start with below-average (cheap) valuations. And the below-average returns group? You guessed it: they start with above-average (expensive) valuations.”

“We’re well into the top 10% of valuations, nearly the top 5% of valuations,” Easterling said, so there’s “a very high degree of certainty that we are set for well below average returns or worse.”

Though this seems intuitive, there’s a widespread belief that stock market returns are completely random and cannot be predicted; therefore, financial planners and investment advisors (human or “robo?) may base their decisions and advice according to the long-term average.

But, as Easterling originally noted in his must-read Waiting for Average report, today’s investors will never achieve the long-term average return of 10% from the stock market, especially given where we are today.

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