by John P. Hussman, Ph.D., Hussman Funds.
Over the past 10 years, the S&P 500 has achieved a total return, including dividends, averaging -0.03% annually. Over the past 13 years, the total return for the S&P 500 has averaged just 3.23%. Why have stocks performed so poorly? One word. Valuation. If investors take nothing else from these commentaries, there are two primary lessons that should be clear. First, the poor market returns that investors have achieved for more than a decade were entirely predictable during the late 1990's, based on the historical relationship between valuations and subsequent returns. Second, from current valuations, the similarly poor returns that investors are likely to achieve over the coming 5-7 year period are also predictable based on the same evidence.
While we regularly emphasize that valuation is not particularly useful as a timing tool, we know of no factor with a better record in setting expectations for long-term market returns. We spend a great deal of time discussing market conditions, economic policy, investor sentiment, and other factors in these weekly comments. But it is critical to recognize that these factors simply modify the short-term course that market returns take over periods of perhaps 1-2 years. They do not significantly affect the long-term course of market returns. Once valuations become unusually rich, disappointing long-term returns become baked in the cake.
We frequently cite our projections in terms of 10-year returns, since that horizon is a common definition of "long-term." Generally speaking, however, large deviations of market valuations from their historical norms have generally been corrected within about 7 years. As a result, 7-year return projections are somewhat more sensitive to overvaluation and undervaluation than 10-year returns are. Think of it this way. Suppose that stocks achieve sub-par returns of 2% annually in order to correct an initial overvaluation, but that after 7 years, valuations are once again normal enough for stocks to achieve 10% annually over the next 3 years. Clearly, the 7-year total return is simply 2% annually. The 10-year total return is a bit less hostile, at 4.34% annually.
I remain concerned about the likelihood of a second economic downturn, and find little in the recent economic evidence (including last week's employment report and the negligible shift in the ECRI Weekly Leading Index to -7%) to reverse that view. That said, we do not rule out the potential for an improvement in economic tone, and will respond to that evidence if and when it emerges.
More importantly, however, investors should recognize that the presence or absence of immediate economic pressures does nothing to change the likelihood that stocks, from their current valuations, will achieve negligible returns in the coming 5-7 years. To understand this, investors need to ground themselves in exactly how reliable valuations - based on smooth, low-variability fundamentals - have been in explaining subsequent market returns throughout history.
Two point six five
If you look through market history prior to the valuation bubble that began in the mid-1990's, you will observe only three times that the dividend yield on the S&P 500 dropped to 2.65%. The precise dates should be instantly familiar. August 1929, December 1972, and August 1987. These dates represented the peaks prior to the three worst market plunges of the 20th century.
Prior to the mid-1990's, the median dividend yield on the S&P 500 had been about 4.1%. Then, the market launched into what would ultimately become a valuation bubble, followed by a decade of dismal returns for investors. Since then, the dividend yield on the S&P 500 has regularly dipped below 2.65%, and as of last week, had dropped to just 2%.
It is not a theory, but simple algebra, that the total return on the S&P 500 over any period of time can be accurately written in terms of its original yield, its terminal yield, and the growth rate of dividends. Specifically,
Total annual return = (1+g)(Yoriginal/Yterminal)^(1/T) - 1 + (Yoriginal+Yterminal)/2
As it happens, the long-term growth rates of S&P 500 dividends, earnings (measured peak-to-peak across economic cycles) and other fundamentals have been remarkably stable for more than 70 years, at about 6% annually, with very little variation even during the inflationary 1970's. Even if one includes the depressed yields of the bubble period, and restrict history to the post-war period, the median dividend yield is 3.7%. Thus, a reasonably good estimate of future 7-year total returns for the S&P 500 is simply:
Total annual return = (1.06)(Yoriginal/.037)^(1/7) - 1 + (Yoriginal + .037)/2
At a 2% dividend yield, this estimate is currently -0.07%.
