Goldman Sachs Destroys An Investing Myth?
2022.04.08 13:25
Did Goldman Sachs (NYSE:GS) destroy a persistent myth about investing in stocks? Sam Ro recently suggested such was the case for the
So, what is the persistent myth that is no more?
As Sam notes in his commentary,
However, here is the key sentence from Goldman’s analysis.
GS-Shiller CAPE & Stastical Correlation
While the analysis is correct, it obfuscates the more important point of valuations and reversions to the mean.
The Mean Has Moved
During extended bull markets, rationalization becomes commonplace to justify overpaying for value. One such rationalization is the permanent shift in valuations higher due to changes in accounting rules, share buybacks, and greater adoption by the public of investing (aka ETFs.)
The chart shows the apparent shift in valuations.
CAPE-Valuation Shift
There are two critical things to consider concerning the shift higher in valuations from 1980-Present.
Read for a more detailed explanation.
However, here is the crucial point on valuations, slower economic growth, and debt from Crestmont Capital.
Of course, since the “ lows, much of the rise in “ has come from rather than actual increases in top-line revenue. The stock market has returned almost 200% since the 2007 peak, which is more than 7-times the GDP growth and nearly 3.5-times the increase in corporate revenue.
SP500-Pull Forward-GDP-Sales
Valuations ARE Mean Reverting
Of course, the surge in the stock market, and valuations, are a function of an $8 trillion-plus increase in the Fed’s balance sheet, several trillion in stock buybacks, tax cuts, and a massive surge in Government liquidity and debt. With price-to-sales ratios eclipsing 3x, a historical record, and median stock valuations near the highest in history, one should question the ability to continue borrowing from the future?
But such explains the step-up in valuations.
While I understand both Sam’s and Goldman Sachs’ views, the flaw in the analysis is using the long-term mean to determine statistical relevance.
A more relevant measure of valuation reversion is by using the exponential growth trend of the valuations over the entire data series. The exponential growth trend captures the economy’s growth, earnings, and inflation over time. Importantly, it also captures the impact of slower economic growth, debt, buybacks, and retail buying in recent years.
Importantly, as shown below, valuations are indeed mean-reverting when it comes to the long-term growth trend of valuations. In particular, very high deviation levels have led to more critical mean-reverting events.
CAPE-Valuations & Deviation From Growth Trend
Notably, while valuations are currently at the second-highest level on record, the deviation from the long-term exponential growth trend is only the 4th highest. Such suggests that while we may indeed see a mean-reverting event in valuation below the long-term growth trend, we may not see a reversion back to 10x valuations or less. This analysis suggests that sub-10 valuations may not be seen again in our lifetimes.
However, while reversions are essential, there is a vastly more crucial point to understand.
Valuations Do Matter
Again, Ben is correct. However, comparing the recent liquidity-driven stock market mania to the 1920s is not exactly apples to apples.
In the short term, over one year or less, political, fundamental, and economic data has very little influence over the market.
In other words, “in the short term.
Price measures the current of the and is the clearest representation of the behavioral dynamics of the living organism we call
But in the long-term, fundamentals are the only thing that matters. Both charts below compare 10- and 20-year forward total real returns to the margin-adjusted CAPE ratio.
CAPE Vs 10 Years Total Returns
CAPE Vs 20 Years Total Returns
Both charts suggest that forward returns over the next decade, or two, will be somewhere between 0-3%.
There are two crucial things you should take away from the chart above concerning the 1920s analogy:
Reversion To The Mean
As Sir Issac Newton once stated:
Looking beyond the very short-term overly optimistic view of the coming unwinding of current speculative extremes will occur after completing the market cycle.
When we look at 10-year trailing returns, there is sufficient historical evidence to suggest that total returns will decline towards zero over the next 5-years from 12% annualized.
SP500-Rolling 10 Year Returns
A decline in the next 3-years of only 30%, the average drawdown during a recession, will likely achieve that goal.
Why will a bear market eventually happen? It is a function of time , math and physics
When will it happen, and what will cause it? No one knows.
While Goldman Sachs suggests there is no evidence of mean reversion, the data clearly shows there is.
Ignoring that data has cost investors dearly.
