By: Dividend Sensei
In part 1 of this series, I explained why UBS’ theory that stocks could go up another 9% in the next year isn’t just plausible, history says it’s actually likely.
However, just because stocks could go up significantly in the short-term doesn’t mean there aren’t smart and stupid ways to try to earn tasty profits.
There is one final fact that investors need to know about the smart way to profit from the greatest bear market recovery rally in US history.
A fact that will both help you maximize your short-term profits, as well as avoid some nasty short-term volatility and potentially catastrophic losses when the party inevitably comes to a halt.
UBS Is Correct About Interest Rates…But There Is An Important Catch
UBS talked about how the average equity risk premium has averaged 3.8% over the past five years.
Five years is not actually a statistically significant period of time in the stock market.
According to JPMorgan Asset Management, the 4th largest asset manager in the world, since 1995 just 45% of five-year returns are explained by fundamentals.
It takes 10+ years for 90% to 91% of returns to become a function of fundamentals.
But there is some good news for bulls hoping UBS is right.
According to Goldman Sachs, over the last 20 years, the equity risk premium has averaged 3.7%.
So what does that mean? That the equity risk premium is relatively stable over time, including the entire modern era that includes interest rates ranging from 0.5% to 6.5%, as well as the current low rate, debt-funded buyback, and Fed QE era.
So that settles it right? Time to plow all our money into the market and make some sweet sweet money right? Actually no. In part 1 I showed how the Congressional Budget Office backed up UBS’s expectation that 10-year yields, the proxy for long-term interest rates, would be at 0.9% through the end of 2021.
That’s the level of interest rates UBS says is required for the market to justify a forward PE of 22 and hit its 3,700 June 2021 target.
But take a look at what the CBO estimates will happen in 2022 and beyond.
- 10-year yields are expected to finish 2022 at 1.1%
- finish 2024 at 1.5%
- finish 2030 at 2.6%
In other words, the CBO estimates long-term rates will rise by about 2% once the economy recovers.
Moody’s has its own estimates of long-term average 10-year yields, and those are 1.75% to 2.25% or basically an average of 2.0%, a 1.5% increase.
The blue-chip consensus among economists, meaning the 16 most accurate out of the 45 tracked by MarketWatch, is for 10-year yields to eventually return to 2.0% to 2.6% as well.
So what does that mean for long-term PE ratios for stocks?
|10-Year Treasury Yield||Historical Fair Value Earnings Yield (3.7% Risk Premium)||Interest Rate Adjusted Fair Value Forward PE||Historical Overvaluation||Market Decline If 10-Year Yield Rises To 2.6%|
That the market’s historical fair value range of 16.5 to 17.5 is where the best economists in the world, expect the market to eventually return.
Does that mean a huge market crash is coming soon? Nope.
It does mean that volatility risk is very high right now and that any one of the numerous risk factors facing us could trigger a historically normal, and healthy correction.
More importantly, it means that over the next 10 years, stocks are likely to see the current 23.6 forward PE (43% historically overvalued) contract by a significant amount.
- the current yield on the S&P 500: 1.74%
- the long-term consensus growth rate (adjusting for the historical probability of recessions): 6.4% CAGR
- valuation drag from PE mean reversion: -3.6% CAGR
- 10-year total return potential: 4.5% CAGR
- probability-weighted 10-year expected return: 3.4% CAGR
Stocks aren’t likely to suffer another lost decade…unless this decade is bookended by two bear markets like the 2000s were.
Rather stocks are likely to merely deliver highly disappointing but perfectly reasonable returns for anyone who understands how the market really works over the truly long-term.
This is the downside of a red hot, TINA/FOMO driven rally.
The bigger downside, from the perspective of most investors, is that stocks never move in a straight line. Buying today doesn’t mean that stocks will just float higher by 3.4% CAGR and end up at fair value in 2030.
Rather the market always trends higher interrupted by periods of intense and frightening (to most people) volatility.
(Source: Advisor Perspectives)
Fortunately, there is a way to not just profit from the great bear market recovery rally in history, but avoid losing your shirt when the party invariably stops, and the bears once more run rampant on Wall Street.