Stocks and Shares

This chart says you should avoid US stocks

Will US stocks go up or down in the near future? Short answer: no one knows. But the long historical record helps us understand what’s likely. US stocks are very near the top of their historical valuation range, meaning the odds are stacked against investors.

There’s no perfect valuation ratio that will give you all the answers. Each has its pros and cons. But when all of them are saying the same thing then there is little doubt.

Right now every measure that analyses the S&P 500 index of US stocks says it’s expensive. Prices are high relative to earnings, net assets, sales and cashflow. (See here.)

What’s more, there’s plenty of evidence that the main thing propping up the stock prices is heavy buying by the companies themselves. (See: The S&P 500 is being looted by management.)

A chief executive can use company cash (or new debt) to buy and cancel shares and quickly drive up the price of his stock options. Or he can invest in company growth and wait years for uncertain results.

Too many CEOs opt for the easier route to immediate personal riches. In the absence of results on the pitch, the players have become the cheerleaders – putting on lycra and waving pompoms, but most definitely not adding to the score line. At least it keeps the crowd happy for a bit longer.

You may conclude, so what? If the price keeps going up and I get a decent dividend then I’ll still do ok.

Maybe. But the usual source of most investor profit – capital gains from growing earnings and assets – will be absent if there’s no reinvestment of profits into company growth.

Even if interest rates stay ultra low for the long term, companies that have been piling on debt to buy their own stock will eventually reach a leverage limit. In the meantime they just keep getting riskier.

Even if interest rates stay ultra low for the long term, companies that have been piling on debt to buy their own stock will eventually reach a leverage limit. In the meantime they just keep getting riskier.

Any analyst worth their salt can come up with a list of reasons why US stocks will keep rising. I could.

But I could come up with a much longer list of why that’s a slim chance, based on more than two decades of experience. Returns on already expensive US stocks over the next five to ten years are likely to be poor.

In fact they’ve already been distinctly sluggish since November 2014. The S&P 500 has moved sideways since then, with two big dips of around 10% – in August 2015 and January 2016 – followed by swift recoveries.

Add in dividends, and total return has been a little over 3% over 18 months, less income tax. My assumption is that, as an OfWealth reader, you’re looking to do a lot better than that.

There’s one chart that I think captures the situation. It’s not something you usually see, but it perfectly illustrates why investors in US stocks are highly unlikely to make good returns in future.

But first a bit of explanation is necessary, so please bear with me. This is slightly technical, but it’s well worth understanding. There’s no better way of cutting through the noise and visualising the poor prospects for US stocks.

The measure I’m focusing on is the P/E10, also known as the Shiller P/E or cyclically adjusted P/E ratio (CAPE). This valuation ratio compares the stock or index price with the average inflation-adjusted earnings per share (EPS) for the previous ten years. That’s a mouthful, so let me explain.

Company earnings are volatile, as economies and businesses go through cycles. This makes the usual P/E, which is based on just one year of earnings (E), highly volatile as well, and sometimes deeply misleading. So the idea with the P/E10 is to compare the stock price with a longer stream of earnings, which are the product of varying business conditions.

EPS from ten years ago is adjusted to add ten years of price inflation, so it’s expressed in today’s money. EPS from nine years ago has nine years of inflation added. And so on, down to last year’s earnings. Then the ten individual, inflation-adjusted EPS figures are averaged to give an estimate of “normal” earnings power, over a decade and in today’s money.

Divide the share price with this average EPS figure and you get the P/E10. This measure has been shown in many studies to have a higher correlation to future investor profits than other valuation measures. It’s not perfect, but it’s the best we’ve got.

Data for US stocks goes back to 1871. Because the P/E10 is based on 10 prior years of earnings it can be calculated back to 1881. This first chart shows how it has fluctuated over that time, with a figure for each month. (Note: this is not yet THE chart, but it will help you understand it better when we get to it.)


The range is from 4.8, the low of December 1920, to 44.2, at the height of the dot com bubble in December 1999. Other notable, single-digit lows were the early 1930s and early 1980s. Other notable highs were 1929 (before the Wall Street Crash), the mid 1960s and mid 2000s (before the global financial crisis).

Doug Short, of Advisor Perspectives, has taken these thousands of monthly data points and shown them in a different way. The result gives great insight into where we are today, and helps to concentrate the mind.

He’s plotted the points on a chart from the lowest outcomes on the left to the highest on the right, irrespective of the month and year when they occurred. At the middle point from left to right, which is the 50th percentile on the horizontal axis, the line is at the median P/E10 ratio of 16.0. Think of that as the “average”.


At the end of April the P/E10 of the S&P 500 was 25.9 – the yellow dot on the chart. That’s 62% above average. It’s only been higher 8% of the time since 1871, which is to say US stocks have been cheaper – and a better buy – 92% of the time.

Excluding the massive speculative markets of 1929 and the dot com bubble (the orange and green dots) then the P/E10 only exceeded today’s level 4% of the time, which is to say it was cheaper 96% of the time. Today it’s also close to the 2007 peak, just before the last market crash.

Put another way, excluding the two biggest speculative bubbles – which were both a disaster for investors who didn’t get out in time – US stocks have only been more expensive than today one time out of 25.

Put another way, excluding the two biggest speculative bubbles – which were both a disaster for investors who didn’t get out in time – US stocks have only been more expensive than today one time out of 25. What’s more, all of those times were just before the last crash. The market then more than halved.

Does that make you confident that US stocks are a good bet right now? It certainly shouldn’t.

To invest in US stocks at this time – and expect a decent profit to boot – you have to be extremely positive about the prospects for corporate profit growth. In fact you’d need profits to grow abnormally fast to justify these levels.

Of course that could happen. But does it sound likely? Not to me. Some businesses will inevitably do well, but others will inevitably do poorly.

I can’t tell you if a crash is imminent, but the downside price risk is clear. If the P/E10 fell to its median level over two years, as happened between early 2007 and early 2009, US stock investors will lose about a third of their investment.

And isn’t it interesting to note that the huge crash during the global financial crisis only took the P/E10 down to its median level? It didn’t even get cheap by historic standards.

Then the Fed and the government stepped in and pumped up the bubble again, with their bank bailouts, ultra low interest rates and quantitative easing (money printing to prop up asset prices).

When the next crash happens I wouldn’t be at all surprised to see the Fed directly buying US stocks, as the Bank of Japan already does in Tokyo. Then it won’t be a stock “market” at all – just a central planning tool that the Soviets would have been proud of.

I hope that doesn’t happen. And I look forward to the day when US stocks offer a cheaper and better entry point. You should keep an eye on the P/E10 while we wait. It’s a good guide to knowing when to buy.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.