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Troubles Ahead For Overvalued Share Markets

Feb 14, 2017


Something tells me 2017 is going to be a year of nasty surprises.

This outlook runs contrary to the current upbeat mood - with overvalued share markets continuing to create history; property values still forecast to rise at a rate well above the growth of the economy that supports those prices; and the US Fed signaling a lift in rates not once, not twice, but three times this year on the back of a stronger economy.

Any knowledge we can glean from those who are seriously connected to Washington and Wall Street's movers and shakers should be of valuable assistance to us. I think we're on the cusp of a historical 'make or break' event...the better informed we are, the better we can survive and prosper from an economic upheaval on a scale that only occurs every third or fourth generation.

The reason for my heightened level of concern?

Read on...

A sneak peek at the in-house research

On a weekly basis, Agora Economics sends me a copy of their latest research, along with views shared by its global line-up of editors. It's always an interesting read.

The weekly email starts with a market barometer...the US market 10-year forecast.

The model is forecasting a minus 8.1% per annum return (in inflation-adjusted terms) over the next 10 years.

Should this eventuate, it means (in simple maths) a loss of buying power over the next decade of more than will turn $500,000 today into less than $100,000 in 2026.

The long-term indicator is based on the 'Demographically Adjusted and Market Adjusted' method (DAMA) developed by Stephen Jones, president of String Advisors.

For anyone interested in Stephen's detailed valuation methodology, here's the link to the 55-page research paper.

For everyone else, this is the condensed, non-technical version.

There are a number of long-term valuation methods - Cyclically-Adjusted Price Earnings (CAPE) 10; Tobin Q; Market Value/GDP (the Buffett Indicator).

The following chart from Advisor Perspectives shows that the US stock market (the market all other markets follow) is touching on valuation levels comparable to the late 1920s. At two standard deviations above the historical mean (an event that's happened rarely in the market's 140-year history), this is one expensive market.

Returns are made when you buy, NOT when you sell.

If you buy at a discount, then future returns are likely to be above average.

If you buy at a premium, then future returns are likely to be below average.

It's a very simple concept to grasp...yet in the midst of a market boom, this concept is forgotten.

Investors inherently tend to buy HIGH and sell LOW.

Stephen Jones has finessed the traditional long-term valuation methods with an overlay that takes into account demographics, government debt and GDP.

His rationale for the impact of debt accumulation on valuation makes sense to me:

  • 'Increases of debt relative to GDP cannot continue over the long term, and because it will incur future costs, the ability of higher debt relative to GDP to continually increase earnings is limited. Likewise, increased savings or reductions in debt would initially create a negative impact on earnings; however, the resulting increased savings or lower debt levels places the economy in a better position to spend savings or increase debt, and thus increase earnings, in the future. Therefore, all else being equal, if earnings-based valuation models use the reported earnings of the overall market, these models should, but fail to, place lower/higher valuation multiples on earnings which are higher/lower due to increased/decreased government debt, relative to GDP.'

Obviously, the injection of debt into the system in the short term will boost corporate earnings. However, continued accumulation of debt means debt-servicing costs in the long term will have a negative impact on earnings.

Global debt to GDP - at 325% - has never been higher. Therefore, the drag of this debt must negatively impact GDP and, in turn, corporate earnings (that are currently being valued on nosebleed price-to-earnings ratios).

In back testing his DAMA methodology against the other valuation methods, Jones' model appears to be far more accurate in its predictive powers.

Just for fun, I thought I'd include the mathematical calculation from the 2015 research paper, which Jones uses to make his long-term forecast.

In June 2015, the DAMA model was predicting a minus 9.39% per annum return over the next decade.

How does this compare to the other valuation models?

The DAMA forecast is by far the most negative outlook of all four methodologies.

However, if you look at the Adj. R2 column, DAMA is claiming a .90 correlation (with 1 being a perfect match) with its forecast returns and what the market has actually delivered.

In support of this claim, the research paper produced the chart below.

The black line is the actual 10-year annual return of the US market. DAMA's forecast is the red line.

While the other valuation methods did not perfectly correlate with actual returns, the wave pattern was in sync.

Which means that, when you look at the far right of the chart, every single valuation method indicates that market performance over the next decade will range between disappointing and devastating.

If DAMA is reasonably accurate, then we are truly looking at a 'make or break' scenario.

A market that falls hard enough to generate a minus 8.1% per annum return over a 10-year period is going to devastate stock-heavy portfolios. But if you manage to avoid the downturn, and can capitalise on the devastation, gains in the double-digits are on offer.

Fortunes are going to be made and lost in the coming years.

Please note: This article was first published in The Daily Reckoning Australia on January 17, 2017.

Vern Gowdie is a contributing editor to Money Morning - Australia's biggest circulation daily financial email. Vern has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia's Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top 5 financial planning firms in Australia. Vern has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession.

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