U.S. Stocks Are Facing Lousy Returns for the Next Several Years

Warren Buffett hasn’t been on his A game over the past couple years. It’s too early to say how his most recent large acquisition – Precision Castparts – will end up performing. But his last major stock market buy – IBM – has been such a lousy performer, we actually shorted it in our monthly Boom & Bust newsletter.

Ouch.

All the same, Mr. Buffett is still a living legend, and his market calls have usually been pretty perceptive. Today, we’re going to look at the valuation tool he has repeatedly called: “Probably the best single measure of where valuations stand at any given moment.”

And that would be the ratio of total market cap to U.S. GDP. Data site GuruFocus tracks the data back to 1970 using the Wilshire 5000 as a proxy for the “total” market cap.

So, how’s it looking? After the third-quarter correction, might stocks be at least modestly cheap?

Not a chance.

U.S. stocks are valued at 118% of GDP. That’s down from the highs earlier this year of 125% and certainly a far cry from the 148% we saw during the “nutty looney” extremes of the 1990s tech bubble. But it’s still extremely expensive. The ratio would have to drop by another 8% just to get back to the levels of 2007… before the 2008 meltdown started.

So suffice it to say, the market is far from cheap. And that implies lousy returns for the next several years. Let’s dig into the numbers.

Investment returns are a product of three factors: dividend yield, economic growth and change in valuation. None of the three look great right now.

Market dividend yields are a puny 2% these days, and GDP growth has been pretty uninspiring. A 2% dividend and 2% – 3% economic growth would get us to 4% – 5% stock returns. While not exciting, that’s not a terrible return in this interest rate environment.

But then we get to valuation. Assuming that the market returns to its long-term average market-cap-to-GDP ratio, the years ahead will be spread thin. GuruFocus crunched the numbers, and based on current valuations the market should return a measly 0.5% per year over the next eight years.

Now, a lot can happen in eight years, and I prefer to leave the precise forecasting to Harry. But it’s safe to say that the odds are not in your favor right now if you’re a buy-and-hold investor.

So if you want to earn a respectable return over the next several years, you’re going to need to be a lot more active and consider strategies you might have never considered before.

As for me, I’m a value investor. I enjoy looking under rocks that other investors might have missed for undervalued assets. But most of the Dent crew tend to focus on momentum strategies. So at first, my comments might seem a little out of place.

But they aren’t. As I wrote recently, both value and momentum, if done well, are proven to be winning strategies over time.

So, my recommendation is this: forget buy and hold for now. There is a time and a place for it, but this isn’t it.

Instead, focus on an active strategy. It can be value-based… or momentum-based… or some combination of the two.

But whatever you choose, make sure it gives you the ability to take risk off the table. Because starting at today’s prices, the next eight years promise to be a very rocky ride.