Today, let’s take a look at the current investment landscape through the lens of risk and reward.
Following are two charts that paint the picture.
1. Return Potential – P/E is calculated by smoothing 10-year earnings. Monthly P/Es (1881 to 12-31-16) are then sorted into five quintiles, lowest P/E to highest P/E (as you read the chart left to right). A high P/E means that the market is expensively priced. The blue bars then show the subsequent 10-year average annualized real total returns that were achieved sorted by quintile. Note the number at the top of each blue bar. That’s the average subsequent return in each valuation quintile. See the red “We are here” projecting 2.2% annualized real returns over the next 10 years. Past history is no guarantee to what the next 10 years will look like, but I wouldn’t stray too far from that bet. I think it is best to play defense and be in a position to play offense when we get to the “We’d be better off here.”
Source: Ned Davis Research
2. Risk – Show this chart to your client. It shows the corrections and the length of days the corrections lasted. Circled in blue are the corrections by percent that occurred in the decade between 2000 and 2010 (left-hand side “Loss %”). For example, the 2001 correction was -30% and lasted 435 days. The 2002 correction took the market down another -32% and lasted about 140 days. Collectively, that compounded to about -50%. The 2009 correction was -55% and lasted about 355 days.
Also, take a look at the corrections in the 1980s (red circles) and the 1990s (light blue circles).
Source: Ned Davis Research
Note that the mean correction for a cyclical bear market that exists within a larger secular bull market cycle is a -21.8% loss that took 211 days. Note too that the mean correction for a cyclical bear within a secular bear market cycle is a loss of -36.9% that took 371 days. For what it’s worth, I believe we sit in a secular bull market cycle.
