As of this writing the S&P 500 is once again testing new highs.  It’s always valuable at such a juncture to consider the two trends that market returns always follow in order to keep one’s perspective within the realm of rationality.

First, there’s cyclical change, best expressed by the adage “What goes up must come down.”  Night always follows day.  Spring always follows summer.  Asset price declines always follow asset price bubbles.  Virtually all world economies go through cycles as growth ebbs and flows due to supply and demand changes and sometimes as a result of government meddling.

Next, there’s secular change.  This usually takes place over longer periods of time and is linear rather than cyclical.  For example, the increase in computer usage worldwide, or enhanced human longevity, caused generally from a long-term positive trend in some aspect of technology, medicine, or human productivity.  Secular change can be very difficult to foresee.  In 1970 the world had 550 billion barrels of proven oil reserves, and President Jimmy Carter was warning that we were likely to run out within a decade.  Over the next twenty years the world used 600 billion barrels of oil, and today the future for oil production in the U.S. is looking quite promising.  Clearly he got it wrong.

U.S. stock market indices, as a measure of business wealth, have naturally exhibited extremely positive secular growth over time, since they are primarily a reflection of the increased valuation of the companies they comprise.  The Dow 30, for example, first reached 1000 in 1972.  It’s now over 15 times higher, and no one to my knowledge, even the most bearish doomsayer, is predicting that it will ever cycle back to 1000 again.  However, it’s important to understand that company earnings are not the only driver of stock returns.  The other key factor is the price that investors are willing to pay for a given level of earnings.  It is expressed as a stock’s price (P) divided by the company’s earnings (E), more commonly written as the company’s P/E ratio.  When investor sentiment turns negative, stock prices will fall even in the face of improving company performance.

I am a big believer in not over-paying for things.  If you’re buying a new car, for example, with a list price of $25,000, would you be willing to pay the dealer $27,000 for it?  (Surprisingly, people do for certain cars when supply is scarce.)  When it comes to stocks, a useful measure of value is the Cyclically Adjusted P/E (or CAPE) ratio, developed by Robert Schiller, professor of economics at Yale University.  This is the average P/E ratio of the entire stock market (as represented by the companies comprising the S&P 500 index) over the past ten years, adjusted for inflation.  Historically this ratio has varied from as low as 5 to as high as 43, with a mean of 15.  Crestmont Research has analyzed stock market returns from 1919 through 2008 and has determined that when the current CAPE ratio is 19, the average return over the next 20 years is only 3.2%.  That’s because over the ninety 20-year periods studied, when the starting CAPE ratio is that high, the ending ratio is usually significantly lower (on average it drops to 9).  A rising CAPE ratio is very positive for stock prices, but a falling CAPE ratio represents a serious headwind to stock returns.

What’s the CAPE ratio today?  Over 20.  That does not bode well for stocks, not just over the next several months but over the next 20 years.  This is not to say that you should avoid stocks.  After all, stocks have historically been the asset class producing the highest returns.  But you should moderate your expectations of stock performance for the foreseeable future when it comes to your retirement and other financial plans.