It was a remarkable year for the US stock market in 2013 as the S&P 500 Index delivered a total return of 32.39%. As one can see in the attached histogram, it was the market’s best year since 1997. That late 1990s bull run lasted until March 2000, but the 1999 results were followed by -9.1% in 2000, -11.9% in 2001, and -22.1% in 2002. Investors were giddy until 2000, but long-term investors who remained in the S&P 500 index for the six years ending December 2002 earned an average annual total return of just 4.4%, which was less than the long-term equity market average return.
The high returns in the late 1990s did not reflect reality. The fundamentals–corporate free cash flows, earnings, and book values–were not keeping pace with market prices and investors were merely “pulling forward” into the late 1990s the returns they could expect to earn in the 2000s. And, the S&P 500 Index fared much better than the NASDAQ composite after the bubble burst. The NASDAQ needs to rise another 24% to match the 5,132.50 it reached at its peak in March 2000; broader indexes have frequently passed old highs over the last twelve months.
After 2002, Greenspan’s rescue took effect and the stock and housing market experienced a brief period of asset inflation, but the bottom eventually fell out in 2008 when the S&P 500 delivered a -37% total return, which was followed by unprecedented monetary stimulus in the form of Quantitative Easing.
So, have we once again merely pulled forward the equity returns we could have expected to earn over the next several years? GMO and others believe that to be true. As of November 2013, GMO expects US large cap stocks to decline 1.3% per year, and US small cap stocks to decline 4.5% per year, for the next seven years, and that is after adjusting for inflation (GMO Asset Return Forecast November 2013). GMO’s expected return forecasts are based on underlying fundamentals and current market prices.
Readers of this blog know that I have periodically published data on Graham/Shiller’s CAPE, Tobin’s Q ratio, profit margins, and other market metrics that all point to an overvalued US market that is likely to deliver low single-digit returns at best over the next seven- to ten-years.
When GMO’s forecasted market returns were low, there was a higher frequency of large declines in stock prices. Wise investors will position their portfolios accordingly.