Estimating expected returns; a 68% market crash

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.

If you’re already a returning visitor, please share this article with a friend.

Free TIP: Check out TIC! It's the distillation of my 30 years as a finance professional


In just 6 weeks of online studies of videos, text documents, screen captures & spreadsheets, The Investing Course teaches you how to Identify, Analyze, Invest, Optimize, Evaluate investments and asset portfolios. It's thorough, pedagogical, easy and fun (well...) for any motivated student.

Join the growing list of very satisfied participants like Pavel Pek below

So far I really love the course!

It's surely more work than I thought to understand all of it (math and logic doesn't really come naturally to me, I am a psychologist by career and humanities oriented my entire life), but it provides me with the exact hobby/intellectual challenge that I was looking for. I also really like the overall background of you Mikael and Ludvig (long time fan of Ludvig's blog) and how the lectures are structured and taught.

The overall system seems to me much more thorough and well thought (esp. the emphasis on the P = FxV formula and the overall picture it so far gave me) of than anything else I found online in my two or so humble weeks of being interested in investing. I am very impressed as yet!

Thanks for bringing this to English.

Glad to hear this can help Karl! Of course, use it with a name, would be glad to spread this course, I take it for an excellent investment that I've made. Best of luck with marketing of this, it's a really awesome system!!


4 thoughts on “Estimating expected returns; a 68% market crash”

  1. 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!

  2. 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?!:-)

    1. 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.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.