Do Bubbles Last Forever?

Executive Summary

Current stock market valuations are pushing the limit of statistical norms. Look at the first graph below which shows the market is over four standard deviations from the mean. Normal statistical distributions fall within four standard deviations 99.9937% of the time! The second two graphs show that when stocks are purchased at these extremes, the future returns are usually dismal. Currently the two authors of those graphs are predicting 7-10 year returns in the range of zero to -5.7% (negative!) depending on the asset class and time frame. The imbedded risk currently is clearly demonstrated, investors should realize now is a time of caution.

Please proceed to read The Details below for more information.

“Once a boom is well started, it cannot be arrested. It can only be collapsed.”
–John Kenneth Galbraith

The Details

Over the past month, I have written about the record state of stock market valuations. In my November 13 missive, I explained what it means to say the stock market is overvalued. In this newsletter, I will briefly illustrate what the future consequences of extreme overvaluations could mean to investors. First, to recap, the following graph from VettaFi shows the Crestmont Price-to-Earnings Ratio which is their proprietary derivation of the Shiller P/E or CAPE. In the graph below, one can see that valuations are now 198% above the long-term mean and are now four standard deviations from the mean. As explained in a prior newsletter, an extreme deviation such as this only occurs about 0.0063% of the time. Or stated differently, outcomes in a normal distribution fall within four standard deviations 99.9937% of the time. This means that what is currently happening is so unusual that, from a statistical perspective, it might occur once, possibly twice, in a lifetime.

The advisory firm GMO, co-founded by Jeremy Grantham, maintains an analysis projecting future seven year real returns for various asset classes based upon current valuations. In their September 30, 2024, analysis, they projected 7-year forward real returns could be around -5.7% for U.S. Large Cap stocks, -4.3% for U.S. Small Cap stocks and roughly 0% for International stocks.

Recently, Marc Fandetti, CFA wrote an article in the Enterprising Investor publication of the CFA Institute. In this article, he included the following graph showing actual subsequent 10-year average annual returns plotted against their Shiller P/E or CAPE Ratio at the start of the 10-year period. Notice that when the CAPE was over 30, the 10-year average annual return never exceeded 0.1% and many of the 10-year periods produced negative annual returns. The current CAPE is 38.7.

Frequent readers know that I often draw on the extensive research prepared by economist John Hussman. Similar to the graph above, except using his favorite and most accurate valuation methodology, nonfinancial market cap/gross value added (including estimated foreign revenue), which is a derivation of the Price-to-Revenue Ratio for the S&P 500, Hussman shows the 12-year subsequent nominal average annual return. The graph below shows that the valuation reading on November 6, 2024, suggests that the next 12-year average annual return could be about -3.46%.

The point of the above analyses is to clarify that extreme valuations (over four standard deviations from the mean) have historically led to a decade or more of negative average annual returns. This is just one more reason for investors to realize now is the time for caution.

The next 10 years or more could lead to much anguish and disappointment for those who believe bubbles last forever.

The S&P 500 Index closed at 6,090, up 1.0% for the week. The yield on the 10-year Treasury Note fell to 4.15%. Oil prices decreased to $67 per barrel, and the national average price of gasoline according to AAA fell to $3.02 per gallon.