Is The Market Still Overvalued? - Thursday, May 6

At the end of last month, the average of the four is 199% — up from 185% the previous month.

Standard Deviation Average

Here is the same chart, this time with the geometric mean and deviations. The latest value of 221% is up from last month's 203%.

Geometric Standard Deviation Average

As we've frequently pointed out, these indicators aren't useful as short-term signals of market direction. Periods of over-and under-valuation can last for many years. But they can play a role in framing longer-term expectations of investment returns. At present, market overvaluation continues to suggest a cautious long-term outlook and guarded expectations. However, at today's low annualized inflation rate and the extremely poor return on fixed-income investments (Treasuries, CDs, etc.) the appeal of equities, despite overvaluation risk, is not surprising. For more on that topic, see our periodic update:

Market Valuation and Actual Subsequent 10-Year Total Returns

Many of our readers have requested we reproduce a chart by John Hussman that inverts the S&P 10-year total returns. Hussman says “the most reliable correlation between valuations and subsequent returns is on a 12-year horizon, which is the point where the autocorrelation profile of valuations typically hits zero.” The correlation of valuations Hussman uses for comparison are at about 90%.

You will notice that nominal returns are used – this is a direct result of a sort of Fisher-effect in which inflation ends up being washed out of the calculation. The nominal growth rate of the economy is highly correlated with the level of interest rates, but also negatively correlated with market valuations, all over the same time period.

Here are the Geometric Average of the Four again and the recreated Hussman charts together. Please again note that the Hussman returns chart is inverted.

Points of ‘secular’ undervaluation such as 1922, 1932, 1949, 1974 and 1982 typically occurred about 50% below historical mean valuations, and were associated with subsequent 10-year nominal total returns approaching 20% annually. By contrast, valuations similar to 1929, 1965 and 2000 were followed by weak or negative total returns over the following decade. That’s the range where we find ourselves today. Of course, we also won’t be surprised if the S&P 500 ends up posting weak or negative total returns in the 2007-2017 decade, which would require nothing but a run-of-the-mill bear market over the next couple of years. - John Hussman

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