The bear market associated with the Federal Reserve monetary tightening and the recent tariff panic has been reversed as the Fed normalizes its interest rate regime. That is the good news. The bad news is that this performance comes once again as the stock market has reaches a new historic valuation extreme, which continues to imply that low expectations for market returns over the next decade continue to be warranted.

The Economy

Reports of the economy are oddly mixed, and the official statistics have had large revisions lately, making the normal conclusions less reliable. By way of example, the Federal Reserve's Beige Book recent survey suggested anecdotally that the economy had "little or no change", while both the Conference Board and the University of Michigan consumer confidence measures reflect levels like or below those of the COVID pandemic. Similarly the Conference Board’s Leading Economic Indicators continue to fall, virtually non-stop, since early 2022. On the other hand, 2nd quarter GDP was revised upward to 3.8%. It may be that this number is simply a temporary aberration caused by a resumption of activity after tariff plans scared the economy into a 1/2% loss in the first quarter, but the Fed's GDP Now real-time compilation of current indicators still suggests a 3.9% annual growth rate though the 3rd quarter.

Despite inconsistent readings and political rhetoric, the labor market has not been significantly affected. The unemployment rate has grown only gradually so far this year, from 4% to 4.3%. Likewise inflation, as measured by the Consumer Price Index, has been relatively muted, with its annual change ranging from only 2.35% in April to the current 2.9% rate. These numbers are also reflected in the country-wide annual increase in single family home prices of 1.9% that is reported by the National Association of Realtors (although the Northeast increase was 6.7%).

The Markets

Gold turned in the best performance during the quarter, rising 16%. The stock market sidestepped its typical August and September weakness. The popular indexes were driven by technology, continuing to levitate off the low after the tariff announcement in April. The S&P 500 recorded new all-time highs both in terms of price and valuation as measured by the so-called Buffet Indicator (total market value divided by GDP). Equal weighted indexes also finished ahead but by a smaller margin.

Longer term bonds began to show signs of strength during the last quarter, outpacing their shorter-term cousins that have led since last year. Typically, longer-term bonds perform well as the economy cools and interest rates fall. This trend could continue if economic activity weakens. It could also reverse if the Fed decreases short-term rates prematurely, causing inflation to rise again.

Here We Go Again

Outlook & Trends has discussed the risks of over-valued markets many times in the past. With the recent increase to record highs and a possible continuation of this trend, it is worthwhile to revisit the concept and implications of valuation. In investment terms, value is what a share of earnings is worth. That share may be paid to the investor in the form of dividends or the additional ownership of a company. The higher the price an investor must pay, the higher the valuation, and the smaller the actual value is received for each dollar invested. As stock market prices are bid up, new investors receive less of the companies' earnings distribution per dollar than investors who bought in at lower prices.

Like all things, valuation considerations are not all quite this simple though. Investors must also implicitly consider whether the return that they get for their dollar of investment is more or less than other investments, primarily bonds. As the interest paid on bonds increases, the competing attractiveness of a stock investment is less. Generally then, stockvalues rise when interest rates fall and vice versa. The bull market of the 2010's was influenced by just this effect. As the Federal Reserve kept interest rates near zero, some investors justified stock purchases at continuingly high prices by calculating that a competing stock valuation level was essentially infinity.

That policy changed in 2022. The Fed increased interest rates and stock market prices (and valuation) fell. Since then, the reverse has happened. Interest rates have come down and the stock prices are rising again. But why are stock values higher than ever before? We can see four contributing factors:

1) The decade of unprecedented Federal Reserve monetary manipulation created an entire generation of investors who believe that the market will always go up with only some minor wiggles along the way.

2) The growth of the payroll deduction 401(k) plans from 1981 has automated investment, especially in unmanaged index funds lately, so that investment values have become disconnected from basic fundamental measures such as earnings. Before that time, companies typically offered pension plans run by value-conscious managers.

3) Many investors (including Wall Streeters and financial advisors) have not seen a significant bear market, have little concept of inherent investment risk, and pay little attention. Parenthetically, the percentage of household assets invested in equities is higher than ever before.

4) There is still a large amount of Federal Reserve-printed assets left over from the Quantitative Easing and Covid policy eras, which provides substantial excess liquidity that is slowly being soaked up by the Fed. This plentiful source of money is available for speculation by those who borrow to try to earn a return that is higher than the prevailing interest rate. Parenthetically, equity margin loans outstanding are also at an all time high.

While it is possible that these trends could continue for some time, it is unlikely that equity values can continue to grow forever and become fully disconnected from reality. Even the Dutch Tulip Bulb Mania came to an end and collapsed eventually. Long-term valuation levels affect future market trends. A higher valuation today implies a lower rate of return in the future. Although the current events or economic forces of today could affect the price of investments 10 years from now, it is safe to say that the current price of stocks will have little or no bearing on the price then.

However, if the current price is less than the currently unknown future price, an investor will have a gain over the period. If the current price is equal to the future price, then the investor will have a lower (essentially zero) rate of return over the 10 years. And of course if the price is higher, the investor would have an even lower return and sustain a loss. In all of the cases, the higher the current value is today, the less the comparative rate of return will be regardless of the future price.

With current valuation measures at all time highs, the mathematical extrapolation of future 10-12 year returns suggest the possibility of low-to-negative returns over the decade. These calculations assume a return to some economic and monetary normality, which may of course not be the case. For example, there is a reasonable chance that more episodes of inflation will leave the price level at the end of the period higher. In that case the apparent return may be positive, while the inflation-adjusted return could be negative. That scenario occurred during the 1970s. In any case, however, that does not change the fact that a high valuation today will produce a lower future return than a low valuation.

What is the take-away from this?

1) People who are investing for a future goal are advised not to assume that future returns will be a continuation of their experience from the last fifteen years.

2) Consider your risk exposure and calibrate your risk to the time when you will need to spend the funds. If you have a 40-year horizon, you can afford to be aggressive and not very concerned about market risk. If you have a 1-5 year horizon, maintaining low risk or managing your investments very carefully is likely to be in order.