Technically Speaking: Forward Returns Continue To Fall

One of the interesting aspects of “bull markets” is the further they go, the lower forward returns fall. In hindsight, such an idea seems counter-intuitive, but ultimately it always comes down to valuations. As Warren Buffett once quipped: “Price is what you pay. Value is what you get.”

When markets are incredibly exuberant, as they are currently, it is not surprising that such is commonly associated with previous market peaks. The chart below shows the annual rate of change of the inflation-adjusted S&P 500 index from March to March. The recent market surge marks one of the largest on record. Such increases typically preceded corrections (10-20%) to outright bear markets.

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Forward Returns Fall, Technically Speaking: Forward Returns Continue To Fall

As we will discuss momentarily, a look at GAAP valuations as a ratio to the “Volatility Index” also finds potential “Trouble in Paradise.”

(Click on image to enlarge)

Forward Returns Fall, Technically Speaking: Forward Returns Continue To Fall

However, despite these more basic understandings, investors still cling to the belief “this time is different.” To support that thesis, investors have pointed to low interest rates as support for excess valuations.

But does that theory hold?


Low-Interest Rates & Forward Returns

We previously discussed whether low rates justified high valuations, to wit:

“The primary argument is that when inflation or interest rates fall, the present value of future cash flows from equities rises, and subsequently, so should their valuation. While true, assuming all else is equal, a falling discount rate does suggest a higher valuation. However, when inflation declines, future nominal cash flow from equities also falls, this can offset the effect of lower discount rates. Lower discount rates are applied to lower expected cash flows.

In other words, without adjusting for inflation and, in no small degree, economic growth, suggesting low rates justify overpaying for cash flows is a very flawed premise.”

Or, as Cliff Asness of AQR Capital confirmed:

Instead of regarding stocks as a fixed-rate bond with known nominal coupons, one must think of stocks as a floating-rate bond whose coupons will float with nominal earnings growth. The stock market’s P/E is like the price of a floating-rate bond. In most cases, despite moves in interest rates, the price of a floating-rate bond changes little, and likewise the rational P/E for the stock market moves little.”

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