Most Expensive Market Ever

A little more than a month ago, we published a controversial note about some research authored by Goldman Sachs. You can read that note here.

It was a note written by their Chief Market Strategist (and my old friend) David Kostin.

In the note, he stated that the stock market might only see a +3% annual return over the next decade. Accounting for an inflation rate of +2%, this would mean only a +1% REAL annual return over the next ten years.

This compares to an average annual return of +11.2% over the last ten years with an inflation rate of +1.9%. That works out to +9.3% REAL return over the period. This is similar to what we have seen for most of the past few decades.

Recently, Bank of America came out with a similar report. Their estimate is even more dire with them expecting a +0% return. You can read about it here.

These reports have received much attention and generated justifiable concern amongst investors.

These are smart analysts working at major firms, and they have some powerful math behind their views.

As we discussed in our previous discussion about the Goldman report, their math is primarily based on "mean reversion." This is the theory that returns and valuations eventually return to long-term averages.

We gave several reasons in that previous report why there may be a rising mean. This means they could be right about the direction, but not by the same magnitude.

Recently, we have also seen many skeptics talking about the stock market's valuation. Here is a chart from a recent Wall Street Journal article…

This metric is Warren Buffett’s favorite measure of valuation and is called the “Cyclically Adjusted Price-to-Earnings” ratio or “CAPE” for short.

This is a variation of the most popular valuation metric, the "price-to-earnings" ratio. This is the stock price divided by the earnings per share or the "EPS."

The CAPE adjusts earnings for inflation and looks at an average over the past ten years. This smooths out the data and reduces the impact of economic fluctuations.

The version we shared from the Wall Street Journal article shows that the current stock market is more expensive than before the 1929 stock market crash. We are not quite at the same level as the 1999 Internet Bubble, but we are getting close.

This is probably the single metric shared the most when discussing the intermediate-term concerns about the stock market.

What do we think of it and the “Lost Decade” thesis?

Well, many of our thoughts are in that previous note we referenced at the start of this report.

Today, though, we wanted to share a couple of other perspectives.

The first is what we have learned to be the primary driver of stock prices over the last three decades of trading and investing – earnings growth and revisions.

Those familiar with our process have heard this many times, but if a company is growing and beating numbers, the stock almost always goes up.

This translates itself to the overall stock market. If most stocks are growing and beating numbers, the overall stock market goes higher.

The valuation never changes that direction.

It may influence how much higher they go or how fast they go higher. In the short term (weeks and months), it may affect the direction, but over a year or longer, it does NOT matter.

If the S&P 500 sees earnings growth and flat(ish) to positive earnings revisions, then the stock market will be up in a year. Maybe up a lot, maybe up a little. Maybe up sooner, maybe up later. It will, however, be up.

This means that the absolute key to understanding the stock market in the intermediate term (one year or longer) is the direction of earnings.

We would go so far as to say that we think it is entirely valid to IGNORE the valuation of the overall stock market and ONLY focus on the direction of earnings.

A stock market that is cheap and sees numbers go down a lot will still go down. Maybe not by as much, but still go down. We have seen it before.

A stock market that is expensive and sees numbers go up a low will still go up. Maybe not as much, but it still goes up. We have seen it before.

Ignore the noise about the “V” word (valuation) and focus on following the earnings to understand the path of the stock market.