My New Theory About Future Stock Market Returns
From: awealthofcommonsense.com
At the lows, the S&P 500 was off roughly 34% from its highs.
From those lows it’s now up almost 25%.
This is confusing to many investors for a number of reasons:
- The economy is still effectively shut down for the foreseeable future
- The unemployment numbers continue to worsen as jobless claims in the past 3 weeks are more than 16 million people (a full 10% of the labor force)
- Even though social-distancing seems to be helping, it appears the coronavirus will be with us for some time
- No one has a clue how this is going to work when we try to turn the economy back on again
I understand the confusion. Markets are seemingly detached from reality at the moment. If you’re not confused you’re not paying attention.
But there are also more coordinated fiscal and monetary rescue measures going on right now than at any time in history. The Fed just announced this week they will:
- Make up to $600 billion in loans for small and mid-sized companies
- Support up to $850 billion in corporate bonds (which includes individual bonds and ETFs)
- Buy up to $500 billion in state and municipal bonds
This is in addition to taking short-term rates down to zero, the $2 trillion fiscal rescue plan and all of the other measures they already have put in place over the past few weeks (with hopefully more on the fiscal side to come).
The economy has been put on ice but the Fed and the government are throwing trillions of dollars to (hopefully) thaw it when the time comes.
I don’t know how this experiment will unfold. Anyone who tells you they do is either delusional or lying.
It’s still far too early to say but let’s assume for a minute March 23rd was THE bottom. I’m not saying this is a fact but let’s say the Fed and the government somehow thread the needle and do enough to keep investors happy during this economic calamity.1
This outcome would be pretty difficult to reconcile with an economy that could experience a contraction that could rival the Great Depression.
I can’t prove this with 100% certainty, but in the past when the Fed either didn’t have the tools (or didn’t use them as they are today) and the government didn’t spend 10% of GDP to help out on the fiscal side of things, the stock market likely would have fallen 60%-70% in this situation.
Many people think this will still happen this time. Maybe they’re right but if not this could have ripple effects on the U.S. stock market going forward.
If the stock market during the worst economic contraction in 90 years can be smoothed out by government spending and Fed actions, does this change the risk-return framework in the stock market going forward?
Said another way — if stocks don’t have the risk of a Great Depression-like crash on the table, does that mean expected returns should be lower going forward?
Looking at valuations over the long-term, you could make the case that the market has been pricing this in for some time now. Robert Shiller has pieced together U.S. market data going back to 1871 to calculate his cyclically-adjusted price-to-earnings ratio.
