QVMS - U.S. Stock Market Valuation Normalizes... Slowly

Summary

• The market’s trend (based on the S&P 500 Index) has remained negatively skewed all along.
• The renewed slide in the stock market implies that the expected return for a relatively long holding period has popped.
• The recent downturn in market prices has taken some of the froth out of market valuation, but only slightly.

Newton famously stated that for every action in nature there is an equal and opposite reaction. The same can be said for the stock market, which is forever discounting the future, albeit imperfectly and sometimes with hefty and long-running doses of noise. Hold that thought as we update the numbers on the assumption that higher (lower) prices/valuations align with lower (higher) expected returns.

The backdrop for our analysis is a summer rally that's stumbled, reportedly because of the latest attitude adjustment on the Federal Reserve policy outlook. As The Wall Street Journal explains: "Hopes for Fed Pivot Have Faded, Sapping Stocks' Momentum" as "Further interest-rate increases threaten to put more pressure on expensive parts of the stock market."

In fact, the market's trend (based on the S&P 500 Index) has remained negatively skewed all along. The recent rally looked encouraging for several weeks, but it was never obvious that the correction's primary trend had switched from bearish to bullish.

The good news for long-term investors is that the renewed slide in the stock market implies that the expected return for a relatively long holding period has popped. How much? Here's where science retreats and the art of forecasting advances.

How many ways can we estimate future returns? Don't ask. Instead, let's favor brevity and a pretty chart and focus on Professor Robert Shiller's Cyclically Adjusted Price Earnings Ratio ((CAPE)), a widely monitored (and sometimes criticized) valuation measure of the US equity market. In the long run, there's the relationship between CAPE values and future 10-year annualized return, but it's prone to plenty of noise in the short run.

Presumably, the recent downturn in the S&P has lifted the expected return. In theory, yes, but there's a glitch: market valuation has (and remains) elevated, based on filtering market returns through a CAPE lens. As such, it's not unreasonable to wonder if the recent theoretical uptick in ex-ante return has been subsumed by a correction in valuation. Using the relationship of CAPE and future 10-year returns since 1971 implies that current market valuation anticipates the S&P 500's future 10-year performance is less than 5% - and that's nominal, before inflation. That's quite a haircut from the current ~11% gain for the past decade (through July based on monthly data).

The recent downturn in market prices has taken some of the froth out of market valuation, but only slightly. Guesstimating the future based on this simple CAPE model suggests the potential for more downside to the future's long-run return before a "normal" relationship between valuation and return (red regression line in the chart above) revives. Timing, of course, is open for debate. Ditto for deciding if a CAPE model is a productive way to estimate expected return. Or, to put it in Newtonian terms: Does (financial) gravity still apply?

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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