Breaking News
0
Ad-Free Version. Upgrade your Investing.com experience. Save up to 40% More details

Technically Speaking: Forward Returns Continue To Fall

By Lance RobertsStock MarketsApr 27, 2021 06:04AM ET
www.investing.com/analysis/forward-returns-continue-to-fall-200575568
Technically Speaking: Forward Returns Continue To Fall
By Lance Roberts   |  Apr 27, 2021 06:04AM ET
Saved. See Saved Items.
This article has already been saved in your Saved Items
 

One of the interesting aspects of “bull markets” is the further they go, the lower forward returns fall. In hindsight, such an idea seems counter-intuitive, but ultimately it always comes down to valuations. As Warren Buffett once quipped: “Price is what you pay. Value is what you get.”

When markets are incredibly exuberant, as they are currently, it is not surprising that such is commonly associated with previous market peaks. The chart below shows the annual rate of change of the inflation-adjusted S&P 500 index from March-to-March. The recent market surge marks one of the largest on record. Such increases typically preceded corrections (10-20%) to outright bear markets.

S&P 500-YoY Returns March-1900-Present
S&P 500-YoY Returns March-1900-Present

As we will discuss momentarily, a look at GAAP valuations as a ratio to the Volatility Index also finds potential “Trouble in Paradise.”

S&P 500-P/E To VIX Ratio
S&P 500-P/E To VIX Ratio

However, despite these more basic understandings, investors still cling to the belief “this time is different.” To support that thesis, investors have pointed to low interest rates as support for excess valuations.

But does that theory hold?

Low-Interest Rates And Forward Returns

We previously discussed whether low rates justified high valuations, to wit:

“The primary argument is that when inflation or interest rates fall, the present value of future cash flows from equities rises, and subsequently, so should their valuation. While true, assuming all else is equal, a falling discount rate does suggest a higher valuation.

"However, when inflation declines, future nominal cash flow from equities also falls, this can offset the effect of lower discount rates. Lower discount rates are applied to lower expected cash flows.

In other words, without adjusting for inflation and, in no small degree, economic growth, suggesting low rates justify overpaying for cash flows is a very flawed premise.”

Or, as Cliff Asness of AQR Capital confirmed:

Instead of regarding stocks as a fixed-rate bond with known nominal coupons, one must think of stocks as a floating-rate bond whose coupons will float with nominal earnings growth.

"The stock market’s P/E is like the price of a floating-rate bond. In most cases, despite moves in interest rates, the price of a floating-rate bond changes little, and likewise the rational P/E for the stock market moves little.”

In other words, if you are going to discount the “P” due to low rates, you also have to discount the “E” as well. Before we get to “earnings yield,” a look at the history of interest rates can tell us something.

The chart below is the “real” S&P 500 index versus the 10-yearTreasury bond. What you will notice is that there is not a high degree of correlation between rates and markets.

10 Year Bond Yields Chart
10 Year Bond Yields Chart

Some Analysis

Looking at the chart above, we find:

  • Exceptionally high interest rates, which have occurred twice, coincided with low stock market valuations. This fact does not prove that high interest rates “cause” low stock valuations. But at least the historical record is consistent with such a statement.
  • Exceptionally low interest rates, which have occurred twice, have coincided with high stock market valuations only once; today. The historical record (1/2 probability) does not validate the highly-confident mainstream narrative that low-interest rates “cause” or “justify” high stock market valuations.
  • Extremely high stock valuations have occurred three times. Only once (1/3 probability) did high stock valuations coincide with low-interest rates; today.
  • If extremely low-interest rates do not cause extremely high stock market valuations, then a rise in rates should not necessarily cause a decline in stocks. That is, the historical record does not support the near-certain mainstream narrative that an increase in rates will torpedo stock prices.

Furthermore, if we run a correlation between 10-year yields and forward returns, as suspected, we find almost no correlation to support the claim.

10 Year Yields Vs Forward Returns Chart
10 Year Yields Vs Forward Returns Chart

Earnings Yield And Forward Returns

As noted, if we are going to talk about low yields, we also need to discuss “earnings yield,” which is simply the inverse of the “price to earnings” ratio.

Historically, when interest rates or infla­tion are low, the stock market’s E/P is also. When isolating periods where interest rates were low, such occurred only twice; in the 1940s and currently. In the 1940s, stock valuations were low, along with interest rates. Therefore, the statement that low-interest rates cause high valuations is a .500 batting average, equivalent to a coin-flip.

However, if we look at periods of exceptionally low earnings yields compared to the market, we find a better correlation to corrections and outright bear markets.

Cyclically Adjusted Earnings Yield
Cyclically Adjusted Earnings Yield

As shown, there is a reasonable correlation between low earnings yields and low forward returns. Historically speaking, with an earnings yield of 2.66%, forward returns over the next decade should be somewhere between +2 and -5%.

Cyclically Adjusted Earnings Yield Vs Forward Returns
Cyclically Adjusted Earnings Yield Vs Forward Returns

But what about the excess yield?

Excess CAPE Yield And Forward Returns

We previously discussed Dr. Robert Shiller’s attempt to justify high valuations. To wit:

“There has been much puzzlement that the world’s stock markets haven’t collapsed in the face of the COVID-19 pandemic. Especially in the United States, which has recently been setting record highs for new cases.

"But maybe it isn’t such a puzzle. A measure we call the Excess CAPE Yield (ECY) puts the long-term outlook for the world’s stock markets in better perspective.”

Essentially, the “Excess Cape Yield” is the difference between the “Earnings Yield” less the “10-Year Interest Rate.” Shiller’s calculation is shown below and compared to the “real” S&P 500 index.

A cursory glance of “low” excess CAPE yields, compared to the index, suggests an alignment with historical market peaks rather than advancing “bull markets.”

Excess CAPE Yield
Excess CAPE Yield

Again, running a correlation of the “excess yield” to forward 10-year returns, we find an even higher correlation between low excess yields and low returns. If we use Shiller’s excess yield of 2.56%, such would suggest that returns from equities over the next decade will likely average between -5% to +5%.

Excess Yield Vs Forward Returns
Excess Yield Vs Forward Returns

Does that mean that every year will be a low return year?

No.

It does suggest that there will be a nasty bear market somewhere along the way.

Conclusion

It is imperative to remember valuations are very predictive of long-term returns from the investment process. However, they are horrible timing indicators.

Beware the investment advisor, pundit, or superstar investor who is sure that extremely low rates cause incredibly high stock valuations.

There is much to debate about the current level of interest rates and future stock market returns. However, what is clear is the 40-year decline in rates did not mitigate two extremely nasty bear markets since 1998, just as falling rates did not mitigate the crash in 1929 and the subsequent depression.

As Clifford Asness concluded:

"So, when pundits say it is a good time for long-term investors to buy stocks because interest rates are low, and then show you something like the chart above to prove their point, please watch the tense of what they say, as what they often really mean is that it WAS a good time to buy stocks ten years ago, as investors are now paying a very high P/E for the stock market (perhaps fooled into doing so by low interest rates as I contend), and the story going forward may be painfully different.”

Do low rates justify high valuations?

History suggests they don’t.

Technically Speaking: Forward Returns Continue To Fall
 

Related Articles

Technically Speaking: Forward Returns Continue To Fall

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind: 

  • Enrich the conversation
  • Stay focused and on track. Only post material that’s relevant to the topic being discussed.
  • Be respectful. Even negative opinions can be framed positively and diplomatically.
  •  Use standard writing style. Include punctuation and upper and lower cases.
  • NOTE: Spam and/or promotional messages and links within a comment will be removed
  • Avoid profanity, slander or personal attacks directed at an author or another user.
  • Don’t Monopolize the Conversation. We appreciate passion and conviction, but we also believe strongly in giving everyone a chance to air their thoughts. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

Write your thoughts here
 
Are you sure you want to delete this chart?
 
Post
Post also to:
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
Comments (3)
stu smith
stu smith Apr 27, 2021 9:01PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
he's been calling for the sky to fall most months.
Steve Won
Hadrian Apr 27, 2021 2:45PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
What would be a great follow-up article is how one should invest when faced with this situation.  It seems like a case of damned if you do (high valuations leading to low future returns for equities), and damned if you don't (no other options that have the potential to generate reasonable return).
jack hong
jack hong Apr 27, 2021 2:45PM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
very difficult question indeed. investors are between a rock and a hard place.
Star Boi
Star Boi Apr 27, 2021 9:41AM ET
Saved. See Saved Items.
This comment has already been saved in your Saved Items
The prevalent market logic you seem to lance-a-lot, poking holes in the pundits thesis. I think you and I both know, there is none. There should be an indicators, like Forward Hope or Future Promise, then there would be no need to dress the pig up as mutton. :P Oh, by the way, thanks for the straight shooting.
 
Are you sure you want to delete this chart?
 
Post
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's Investing.com's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Disclaimer: Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.
Continue with Google
or
Sign up with Email