Along those lines of thinking, I sought out some market research on S&P returns at various times in history. For example, I found a great academic paper written in 1997, illustrating why S&P returns would be most likely very weak over the following 5 years. He was right, the market was about flat, and everybody and their brother was extremely bullish then. For the record the S&P was up a little, 6% cumulatively in the following 5 years, but with terrible up and down volatility. Bonds did a lot better.
I was also reminded of a conversation that we (at one of my old hedge funds) once had with Warren Buffett. This was 8 or 9 years ago, but very relevant to today. Buffett discussed why the stock market environment was so perfect in 1980. As I recall, he noted that, at that time, profit margins were at historical lows. Not only that, but P/E ratios in 1980 were also at near all-time lows in the single digits. With tightening monetary policy under Paul Volcker at the time, it was most likely that interest rates would go down. They did, and, typical of markets, P/E ratios tend to move up when rates go down. (we all know that stocks are merely the discounted value of their future cash flows, so if rates go down, valuations and P/Es go up).
So the next 20 years were fantastic for equity market investors in the US. Margins improved dramatically, and valuations improved as well. Fast forwarding to today, I basically wanted to paint a Jeremy Grantham-esque type picture of what I think the markets will do for the next 5 to 10 years. In essence, market prices depend on a range of factors: current earnings levels, expected growth in earnings, interest rates, profit margins, and where you can expect to sell stocks at the end of the period. That is, what kind of P/E ratio will the market trade at in 5 years, when you sell your equities?
EARNINGS
So first of all, let's examine earnings. What will earnings look like in 5 years? What I found in doing some digging was that REAL earnings growth has been quite stable over a very long period of time. By real, I mean adjusted for inflation. Turns out, since 1930, S&P earnings have grown (on average) at a 1% real growth rate per year. That answers one question, that is, what will the E in P/E be in 5 or 10 years. However, I also noted that profit margins tend to swing pretty dramatically too, mostly due to the boom and bust nature of our economy. But, most importantly, it has to be noted that profit margins are strongly mean reverting.
Take a look at this chart on profit margins over dating back to 1955.
While this chart isn't updated to today, I found that we had a very similar dip in margins in 2008 and 2009, with a bounce back to the highs again in 2011. Today, Q1 S&P 500 profit margins are hitting near peaks at 8.4%, versus a historical range of 5.5% to about 8%. Furthermore, I found that since 2000, profit margins have averaged 7.3%, about 1.1% lower than today.
So, if you think that profit margins continue to expand, then likely you will view the market as very cheap. However, the inevitable recessions mean that we will more likely see profit margins falling, then rebounding again during the next recovery. I do note, however, that today's unemployment rate at 8.9%, a very high number historically, means that there will be less wage pressure, and margins may remain higher than historically was the case. The huge fall in margins in the chart above, in 2000, was likely due to the fact that a recession, coupled with sub 5% unemployment, meant corporations couldn't cut wages at all. Net net, margins got crushed. Likely it wont be as severe during the next recession.
INTEREST RATES
Historically, P/E ratios tend to be tied to rates. When rates are high, as in the late 1970s, P/E ratios tended toward the 7-10x range. When rates are low, P/E ratio's tend toward the higher end of the range, about 15-20x. So, what is the right assumption in 5 or 10 years for rates and P/Es? I don't honestly know, but I would say that we are far more likely to see higher rates (and lower P/Es) than we have today. I wouldn't be surprised if we had 4-5% inflation in 5 years, and P/E ratios in the 10-14 range.
So, let's look as some scenarios.
SCENARIO ONE (OPTIMISTIC CASE)
Let's assume in 5 years, we have similar high profit margins of 8.4%, that real earnings grow at 1%, and that P/E ratios are 13-17x. Here is what S&P 500 returns look like:
S&P EPS: $114
| 5 Years | P/E Ratio in 5 Years | ||
| 13 | 15 | 17 | |
| S&P Level | 1,809 | 2,087 | 2,365 |
| Appreciation | 3.20% | 4.69% | 6.01% |
| Dividends | 1.78% | 1.78% | 1.78% |
| Total Return | 4.98% | 6.47% | 7.79% |
Not bad, 5% to almost 8% per year returns.
SCENARIO TWO (EXPECTED CASE)
Let's assume in 5 years, we have profit margins of 7.5%, which is slightly above the average margin since 2000. Real earnings grow at 1%, and P/E ratios are between 10 and 14x. I call this the most likely case, as 1) profit margins will remain higher than historicaly averages, given high unemployment today. 2) interest rates likely will go up with inflation and deficit issues in the US, causing lower P/E ratios than we see today. So, given that, here is what S&P 500 returns look like 5 years out:
S&P EPS: $99.39
| 5 YEARS | P/E Ratio in 5 Years | ||
| 10 | 12 | 14 | |
| S&P Level | 1,021 | 1,225 | 1,430 |
| Appreciation | -2.53% | -0.74% | 0.80% |
| Dividends | 1.78% | 1.78% | 1.78% |
| Total Return | -0.75% | 1.04% | 2.58% |
Not that exciting. I am getting annualized returns between -1% and 2.6% per year.
DOWNSIDE CASE
One has to consider the downside case to get a feel for risk reward overall. If the upside is 7% per year, and the downside is flat, then you should probably be in stocks. Let's take a look.
I assume we have a better outcome than 1980, although with inflation worries creeping into the picture, I would posit that the probability of this outcome is far from remote, and quite high, perhaps 20-30%. Here I assume we have 6% profit margins, and 7-11x P/E ratios, both better outcomes than we saw in the early 1980s.
S&P Earnings: $82
| 5 YEARS | P/E Ratio in 5 Years | ||
| 7 | 9 | 11 | |
| S&P Level | 572 | 735 | 899 |
| Appreciation | -8.03% | -5.68% | -3.77% |
| Dividends | 1.78% | 1.78% | 1.78% |
| Total Return | -6.25% | -3.90% | -1.99% |
This is pretty ugly, and not terribly far off from what happened from 2000 to 2010.
S&P FAIR VALUE TODAY
Perhaps a better way to look at this would be to ask, what is fair value of the S&P today? That is, given the case we are expecting 5 years from now. That is easily determined, all one has to do is discount that future S&P level by the rate of return we think is appropriate for stocks. Simply put, what kind of return would you demand to own stocks for 5 years?
Given long dated bonds are yielding 4.4%, I would think that something in the 7-9% neighborhood makes sense, which is about a 4-6% real return given inflation today. So, if the S&P could be around 1225-1430 in 5 years under our expected scenario, that equates to an S&P fair value estimate of around 960-1120. These are levels where I would meaningfully add exposure to US equities.
CONCLUSIONS
So today, we have equity markets trading at average P/E ratios, but against peak margins. I suspect this points to full valuations, and certainly the US market is not cheap. This chart brilliantly illustrates how bullish sentiment tends to get too high, but mostly when margins are at their peak:
We are currently in the highest 20% of margins. In fact, probably in the top 5%. However, at least the median P/E today of 15x isn't as high as the 25x in the chart. Nevertheless, its clear that market tops form when profit margins peak, and vice versa. I should point out though, that its possible that we WILL get 20x P/E ratios in the next 1-2 years, as bullish sentiment becomes a full bubble, indicating that the market could top 1600-1800. I wouldn't make rational investment bets with this possibility however, and honestly find its more likely we'll have a pullback/correction after QE2 ends this June. So, clearly we aren't in bubble territory yet, just a fully valued market. I think holding 25% of my assets in stocks, another 10% in precious metals makes a lot of sense.
Finally, as per bonds, research shows that when bond yields are materially lower than S&P earnings yields (the inverse of the P/E, not dividend yields), then it doesnt bode well for fixed income, although its less conclusive on the market's direction. Sell duration, own perhaps 25% in equities, and keep some commodity exposure as inflation insurance.
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