Given the wild swings in the market this month, I’ve been getting a lot of questions. Or rather, I’ve been getting a lot of variations of the same question: Is this the end? Is the market topping?
Anyone who gives you a definitive answer to that question is either delusional or a charlatan. Or both.
No one knows if this is the top or not. They don’t ring a bell at the peak of the bull market and tell everyone to get out. It doesn’t work like that.
Market tops and bottoms are more of a process than a specific event, as countless investors sort through the noise and place their bets. We won’t definitively know if the July blow-off marked the top for months… or maybe even years.
But here’s the thing. Anyone asking if this is the top is asking the wrong question. If you want a meaningful — and tradable answer — you have to ask the questions differently.
What are my expected returns going forward? And…
Am I taking the right amount of risk?
Let’s start with the first question.
Long Term Forecasting
I’ve never met anyone that could consistently forecast what the stock market will do over the following year. There’s just too much noise and too many unknowns. What if the Fed lowers rates more than expected? What if the U.S. gets dragged into a war in the Middle East or the South China Sea? Or what if something that’s not on anyone’s radar comes out of the clear blue sky?
There’s just no way to model how the market will behave over a window that short.
But over a 7- to 10-year window, fundamentals and pricing start to matter again. The noise gets cancelled out and you can make reasonably good guesses about what stock and bond returns will look like based on historical precedents. It’s not surgical precision, of course. But it’s good enough to make a proper asset allocation.
One of my favorite long-term forecasting tools is the cyclically-adjusted price/earnings ratio, or CAPE. The measure compares today’s stock prices to a 10-year average of company earnings with the idea of smoothing out the ups and downs of the economic cycle. It’s next to useless in forecasting the S&P 500’s returns over the following year or two. But it’s fantastic for finding long-term entry and exit points.
What Are My Expected Returns Going Forward?
Today, the S&P 500’s CAPE sits at a lofty 29. That’s 70% higher than the long-term average of 16.1 and it implies that, if history is any guide, the S&P 500 should lose about 1.4% per year over the next eight years.
If interest rates stay low, that number might end up being a little higher than that. Maybe the S&P 500 returns 1% to 2% per year rather than losing 1.4%. Don’t get fixated on the precise number. The takeaway is that, at current prices, stocks are priced to deliver really crappy returns over the better part of the next decade.
As with a medical diagnosis, it’s always a good idea to get a second opinion. I’ve always had a lot of respect for Jeremy Grantham of Grantham, Mayo, Van Otterloo & Company. He’s one of the best value investors walking the earth today, and his firm publishes a fantastic seven-year forecast every quarter.
Well, Grantham’s crew has an even more dismal outlook. Based on their analysis, large-cap U.S. stocks are priced to lose 3.8% over the next seven years, and small-caps are priced to lose 1% per year.
Perhaps even more depressing is that they see U.S. bonds losing 1.7% over the next seven years.
Again, I don’t expect stocks to lose exactly 1.4% or 3.8%. If it happens to work out like that, it would be a lucky coincidence.
The takeaway is simply that stocks are a lousy bet at current prices, and bonds aren’t much better. If you’re plowing money into your 401(k) every year, that’s a depressing thought.
There Is A Better Way, However
Last week, I shared how to turn your 401(k) into a “1201(k)” by snapping up high yielders that are off the radar screen of most investors. And there’s still time to take advantage of this opportunity.
Click here to find out more about this strategy and how it can guide steer you to higher returns even as the broader market continues to chop sideways.