Reading time: 3 minutes – forever*
Executive summary: Just plug in market sales growth, future (trough) sales multiple, yield and the time for valuation adjustment; and get your 2-year 68% market crash
*Depending on your background, this article, about assessing total stock market returns during bull markets and crashes, might take between 3 minutes and forever to read.
Total stock market returns
The math is never hard in equity analysis. It’s all about the assumptions.
Either you think you have an edge in calling the future, or you don’t. If you don’t, a decent assumption is that history repeats or at least rhymes.
When assessing the potential of the entire market, the following is a simple, albeit quite powerful, tool (my thanks to Hussman for the inspiration):
(1+g)*([MC/GDP]average / [MC/GDP]now)^(1/Time Period) – 1 + Dividend yield = annual total return over the Time Period
g=annual sales growth, MC/GDPaverage=historical average for Market Capitalization/GDP, MC/GDPnow=current MC/GDP, Time Period=time in years for adjusting valuation multiples to their historical average
The formula calculates the total stock market returns during the coming T years, given valuations during that time span return to their historical averages, i.e., history repeats itself when it comes to profit margins and valuations.
If we assume (you know what they say* about that, don’t you?) 6% average revenue growth going forward, and plug in the average MC/GDP number of e.g. 0.63 (Hussman has a 0.55 here) as well as the current MC/GDP number of 1.35 (or whatever it might be when you are reading this), take it to the inverse power of the number of years, minus 1, and finally adds the average dividend yield over the period, this is what we get.
The current situation, give or take
(1.060)(0.63/1.35)^(1/10) – 1.0 + .018 = 0% total annual returns over ten years
Quick adjustment scenario
If you want to assume the MC/GDP ratio reverts back to its historical mean in just 24 months, this is what you get:
(1.060)(0.63/1.35)^(1/2) – 1.0 + .018 = -26% total annual returns over two years; or a total return of -45% for the two years. After such a re-set the market would be ready for 7.8% annual returns for the foreseeable future (6% growth, stable valuation multiples and 1.8% dividend yield).
See below for more examples
The following table shows yearly returns during a three-year adjustment period
Yes, you read it right, the top left cell estimates three consecutive years of -30% market returns
If you are retarded you could focus on the bottom right cell, which says 7% annual returns the coming three years, i.e., if you estimate both the current and future GDP multiples at 1.0
Is a -68% stock market crash something you could be interested in?
There are both worse and more optimistic scenarios than the one above.
On the downside, you probably should expect an undershooting, an “inversion” of the current valuation overshoot. Plugging in a (not that unusual) 0.37 trough MC/GDP in the formula, simultaneously with just 4% annual nominal GDP growth, renders a 10 year return of -7% per year for a decade, or a 68% crash in two years.
The upside is that after such a crash, the market is like a loaded spring, ready to perform 14% per year on average for a decade – which would be more or less a typical bull market. If history is rhyming, and considering all the extremes in debt and valuations etc., it would be about time we had a real crash followed by a strong bull market.
What are your best guesses for the input variables?
- Market Cap/GDP is irrelevant (e.g., due to permanently changing profit or cash flow margins, tax rates, proportion of economy listed etc.); use another valuation gauge
- However, in this article Dr Hussman shows that MC/GDP (actually nonfinancial market capitalization/corporate Gross Value Added) has a 91% correlation with subsequent market returns
- 6% annual (nominal GDP) growth is too high/low (remember to adjust the growth rate according to your choice of multiple)
- The future MC/GDP multiple will be higher/lower than the historical average
- The current MC/GDP multiple isn’t 1.35
- The average dividend ratio will be much different from 2%
- The valuation adjustment will be quicker/slower than 2-10 years
* To assume is to make an ass of u and me
Just remember, stock markets do not crash due to high valuations. They crash when investors are spent mentally and shy away from risk instead of chasing it blindly.
Single stocks
Hang on.
There is more.
You shouldn’t use the above formula for single stocks (for many reasons), but there is a kind of equivalent method I like to use as a sanity check when researching stocks.
More about that later this week. Sign up for my free newsletter to make sure you don’t miss it. You’ll get the link to my free eBook The Retarded Hedge Fund Manager as well.
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Thanks for bringing this to English.
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LOL, I’ve called nearly every damn top and bottom in the stock market and the precious metals market.
Let’s talk about CUCKMAN. The guy is a loser.
http://finance.yahoo.com/echarts?s=HSTRX+Interactive#{“range”:”10y”,”allowChartStacking”:true}
LOL
We are in a bear market, started in April, it takes some time to realize you are in one… Many investors struggle during bear markets cause they want it to be a bull market, they hold on to their positions too long and sell in panic at the lows. Be active if you get 10-15% bounces use it to take some money off the table and wait for the market to come down again! Never panic on the upside, add dicipline to your strategy and you will do great! Enjoy the ride!
Would be interesting to see similar calculations for, let’s say, Austria, Greece, Russia, Portugal, Brazil, Turkey and a few more dogs. Perhaps there is value somewhere in the World, if you look carefully enough?!:-)
Yes, definitely. No doubt there is always value somewhere. The money sloshes from place to place, from asset class to asset class, creating cycles of over- and undervaluation.