Stocks to lag bonds and even decline over next 10 years, says valuation model based on eight indicators

For the first time in years, valuation-focused advisors have something to brag about as they approach the end of the year.

This year-end time is when it’s traditional to review previous year’s forecasts, celebrate successes, and evaluate what went wrong with failures.

A year ago, I reported that valuation models with the best track records were concluding that the stock market was grossly overvalued. The S&P 500 SPX index,
-0.04%
has dropped 18% since then, and the technology-oriented Nasdaq Composite Index COMP,
-0.48%
is down 29%.

It would be premature for consultants employing these models to break their own bottles of Champagne. They have been warning of an impending bear market for years and until this year they were wrong.

In previous years, they have defended themselves by arguing that valuation models are not short-term indicators, but should instead be judged over the long term. It’s not fair for them now, in the wake of a calendar year that has finally followed their predicted bearish script, to suddenly focus on the short-term.

The most intellectually honest exercise is to remind everyone that valuation models have little, if any, predictive power over the one-year horizon. To the extent that their track records are impressive, it’s over much longer time horizons, like a decade.

The accompanying chart shows, for the eight valuation models I monitor regularly in this column, what they predicted a decade ago. (See below.) On average, they projected that the S&P 500 would produce an inflation- and dividend-adjusted return of 5.2% from then through today.

I give that average prediction an up vote. On the one hand, it was significantly less than the 9.7% annualized total real return that the stock market has actually produced since then.

On the other hand, these models correctly predict that stocks will far outnumber bonds. A decade ago, 10-year Treasuries TMUBMUSD10Y,
3.728%
they would have produced a negative 0.7% annual real total return over the next decade, based on their current yield and the then prevailing 10-year break-even inflation rate. As it turned out, 10-year Treasuries have actually produced a negative 2.6% annualized real total return from then until now.

In other words, these valuation models predicted 10 years ago that stocks would outperform bonds over the next decade by an annualized margin of 5.9 percentage points. While much smaller than the 12.3 percentage point annualized margin by which stocks have actually outperformed bonds, investors who have followed suit in these models presumably aren’t too upset at being turned away from bonds to stocks.

As you can also see from the chart, the current 10-year average equity market projection of these eight models is a total real return of minus 1.0% annualized. Not only is that much lower than the average projection of 5.2% a decade ago, it is even lower than the projected gain for 10-year Treasuries of 1.4% annualized above inflation. So these models currently tell us that the return on equities over the next decade will be much lower than it was before, and may even underperform bonds.

How valuation models stack up historically

The table below shows how each of my eight rating indicators compares to its historical range. While each is suggesting a less overvalued market than prevailed earlier this year, they are not yet projecting a massively undervalued market.

Last

One month ago

Beginning of the year

Percentile since 2000 (100 most bearish)

Percentile since 1970 (100 most bearish)

Percentile since 1950 (100 most bearish)

P/E Ratio

21.48

20.65

24.23

48%

66%

75%

CAPE report

29.29

28.22

38.66

76%

83%

87%

P/dividend ratio

1.68%

1.72%

1.30%

78%

84%

89%

P/Sales Ratio

2.42

2.33

3.15

90%

91%

91%

P/Book Ratio

4.02

3.87

4.85

93%

88%

88%

Q Ratio

1.70

1.64

2.10

88%

93%

95%

Buffett ratio (market capitalization to GDP)

1.59

1.54

2.03

88%

95%

95%

Average household equity allocation

44.8%

44.8%

51.7%

85%

88%

91%

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Rating tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

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