Thoughts from the Frontline: Can It Get Any Better Than This?

As I write this letter from the Maine woods, the S&P 500 has just cleared 1,700 for the first time. The German DAX continues to set all-time highs above 8,400. The United Kingdom’s FTSE 100 is quickly approaching its 1999 record high of 6,930, and its mid-cap cousin, the FTSE 250, just broke through to its all-time level above 15,000. And last but not least, Japan’s Nikkei 225 is extending its gains once more, toward 14,500.

This weekend I am sitting around with some of the smartest economic and trading minds in the country. At Leen’s Lodge, where we’re fishing and eating where our phones don’t work, the question on our minds is, how long can this run go on? The debates can get intense in a room full of strong opinions. So, with a little help, I did some research on what our forward-looking prospects are for the markets.

Let me take this opportunity to introduce a new name to readers, one that will become familiar over the next few years. I have gotten to know Worth Wray, a young economist (though I should say that, as I stare 64 in the face, a lot of people are looking young these days) who has really impressed me with the breadth of his knowledge and insights. He was the former portfolio strategist for my good friends at Salient down in Houston, and they were kind enough to let me entice him to come to Dallas to work with me.

This is a big move for both of us, and I am finding that it’s one I should have undertaken a long time ago. Worth is really going to help me expand my abilities to do research and present my thoughts to you. I asked him a few questions, and he helped me tee up this week’s letter. Plus, we’ll look across the Pacific, and I’ll share some thoughts I’ve had about an interesting black swan that could be developing in the Korean Peninsula. Let’s get started!

Can It Get Any Better Than This?

To many investors, developed markets appear healthier and stronger than they have in years. Major equity markets are rallying to record highs; corporate credit spreads are tight versus US Treasuries and getting tighter; and broad measures of volatility continue to fall to their lowest levels since 2007.

This kind of news would normally point to prosperity across the real economy and call for a celebration – but prices do not always reflect reality. Moreover, the combination of high and rising valuations, low volatility, and a weakening trend in real earnings growth is a proven recipe for poor long-term returns and market instability.

Let’s take the S&P 500 as an example. It returned roughly 42% from September 1, 2011, through August 1, 2013, as the VIX Index fell to its lowest levels since the global financial crisis. Over that time frame, real earnings declined slightly (down about 2% through Q1 2013 earnings season), while the trailing 12-month price-to-earnings (P/E) ratio jumped 44%, from 13.5x to 19.5x. That means the majority of the recent gains in US equity markets were driven by multiple expansion in spite of negative real earnings growth. This is a clear sign that sentiment, rather than fundamentals, is driving the markets higher.

Of course, the simple trailing 12-month P/E ratio can be misleading at critical turning points if you are trying to handicap the potential for long-term returns. For example, the collapse in real earnings during the global financial crisis sent the S&P 500’s trailing P/E multiple through the roof by March 2009. So, while trailing P/E is a useful tool for understanding what has already happened in the market, the “Shiller P/E” is far more useful for calculating a reasonable range of expected returns going forward. This approach won’t help you much with short-term market timing, but current valuations have historically proven extremely useful in forecasting long-term returns. In his book Irrational Exuberance (2005), Robert Shiller of Yale University shows how this approach “confirms that long-term investors – investors who commit their money to an investment for ten full years – did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well-advised, individually, to lower their exposure to the stock market when it is high … and to get into the market when it is low.”

Excerpted from Thoughts from the Frontline – a free weekly publication by John Mauldin, to read the full article– please click here.