“A man without hope is a man without fear.” —Frank Miller
Have you watched Daredevil at all on Netflix? Admittedly, there are moments of violence that would put off some viewers, but it’s an excellent show. And it brings back to mind all of the great work that Frank Miller did on the title character a couple decades ago. The quote above, in particular, stays with me.
We've heard a lot about hope and fear this year in the context of the presidential election. Some might even argue that the election hinged on those two emotions. But enough about politics. Instead, I'd like to talk about the relative levels of fear and hope in the market, and see whether there’s anything to learn about what’s going on there.
It's important for investors to remember that at all times, in all circumstances, the stock market is mostly pricing in expectations about the future. About how the profits of companies, in particular the distributable profits, will grow or decline, how fast the growth will be, and what sectors might see a decline. Any time you look at the market and the stocks within it, you’ll find many data points you can use to determine whether stocks “look” expensive or cheap. For every metric that suggests that now is a good time for investors to be hopeful, there will always be several other ones you can look at that will say the opposite.
Here are some important examples.
The market, as measured by the S&P 500, has had positive returns for seven years in a row, and 2016 looks well positioned to be the eighth. The last two times the market had nine years in a row of consecutive positive returns — 1991-1999, and 1920-1928 — things ended with huge market crashes in the following year. So should you be hoping for positive returns in the market at all in 2017?
Stocks are trading at a Shiller P/E of over 27 (the ratio of price to average inflation-adjusted earnings over the past 10 years), which has essentially been surpassed three times — 1929, 1998-2000, and 2007. All of those turned out to be rather poor times to invest, at least over the short term.
(Note: "P/E" alludes to the price-to-earnings ratio. Generally speaking, a company's P/E ratio is defined as its stock price divided by its earnings per share.)
Those two ways of framing this moment in time might seem alarming for today’s investors. On the other hand, consider these words from legendary investor John Bogle in 1998:
"The fact is that for more than two centuries, the U.S. stock market has demonstrated a profound tendency to provide real (after-inflation) returns that surround a norm of about 6.7%. [T]he swings around this norm over moving 25-year periods are reasonably narrow, with returns much above 10 percent in only 7 of the 172 periods and returns much below 4 percent in another 5 periods. In short, real returns have ranged between roughly 4% and 10% in 93% of the 25-year periods, a remarkable record of consistency." -- Bogle on Investment Performance and the Law of Gravity: Reversion to the Mean -- Sir Isaac Newton Comes to Wall Street
The Current State Of The Market.
Let's take a quick look at how the market has done over the last 25 years. From November 1991 to November 2016, it has provided 6.85% annual returns, after accounting for inflation. That is, returns over the past quarter-century are exactly in line with what you (or John Bogle and Jeremy Siegel, at least) should probably have expected. 1991 was not a time of particularly elevated prices. Going back in time, we would have expected pretty normal returns from that starting point, which is what we’ve received.
Here at the end of that period, however, we find stocks looking fairly expensive compared against historical norms. Moreover, while a quarter-century of normal returns has been achieved, it hasn’t been accompanied by “normal” American economic expansion. If we are to achieve the normal expected returns in the market over the next 25 years, what are the paths to get there?
Remember that returns, put simply, are going to be a function of the economic performance of the companies within the market and the multiple that people will pay for their earnings in the future. Normal returns over any period can be achieved by normal economic performance and a similar multiple paid at the end of the 25-year period as at the beginning. If the next 25 years are to produce average returns, there are two paths -- excellent economic performance by businesses and a return to more normal valuations, or average economic performance and maintained elevated valuation multiples.
Either is possible, as are less pleasant scenarios. Average economic performance combined with a return to historic multiples produces sub-standard, perhaps even extremely sub-standard, returns. Continued sub-standard economic performance combined with a return to normal valuation multiples would provide real returns significantly less than 6.7%.
Why We're Hopeful, But Cautious.
Given today’s multiple, we can conclude that there is a lot of hope priced into the market. It’s either hope that a return to economic growth more in the 3%-4% annual range seen in many prior periods is possible, or that the valuation range the market has more or less maintained for the past two decades represents a “permanently high plateau” (to borrow an alarming phrase from the past) that we can rely on seeing in the future. Both are possible, and they represent a pretty sizeable helping of hope. Not irrational hope, but hope nonetheless.
And a market with hope, returning to our opening quote, is most certainly also a market with fear. Any observation that the market is trading at high levels, however those highs are defined (record market highs, above-average multiples, multi-year strings of positive returns in the market), is a reminder that high levels do not sustain themselves inevitably into the future. Crashes happen, and the next 25 years is highly unlikely to provide an exception to that historic rule.
Here at Motley Fool Funds, we tend to be more guided by hope than fear, and we still see some investments that are attractive in today’s market, though fewer than we saw earlier in the year. (Note our commentaries in January.) But balancing all that can go right against all that can go wrong, we return to John Bogle’s observation. Equity returns revolve around fairly narrow and positive ranges over long periods of time. That the past 25 years hits the average right on the head is more coincidence than anything else, but it also lends some support to the idea that we have not borrowed the positive returns we are enjoying of late from the future. Returns are about what we could have expected, though not arrived at by the path we may have expected.
(Note: Securities in the Funds do not match those in the indexes and performance of the funds will differ. It is not possible to invest directly in an index. For current fund performance, please visit https://www.foolfunds.com/our-mutual-funds/.)