The US stock market record to date has been unprecedented. Since March 2009 a 500 Index increased steadily from 683 to the current 2,840, or +316%. It has taken over 9 years to surpass prior records for the longevity of the cycle.
Time has now come to check up how the prevailing stock market levels may be approaching the possibility of a recession.
The stock market is presently significantly overvalued. Based on historical ratio of total market cap over GDP is currently at 143.9%. With such high values the stock market is likely to return -2.2% a year from this level of valuation, including dividends. If an investor currently decides to purchase an average US stock, the expected future returns will be negative because the purchase price will not be supported by sufficient cash income.
As of today, the total market capitalization is $29,369 billion. The US stock market reflects low average annualized return based on an estimate of the historical valuation of the stock market. It has been pointed out by Warren Buffett that a percentage of total market cap (TMC) relative to the US GDP is “probably the best single measure of where valuations stand at any given moment.”
If there is a recession, the S&P 500 Index can be expected drop at least 44% in the average valuation of an investor's portfolio.
Another way of making valuations is to use the Shiller P/E (Price/Earnings) Indicator. Presently the Shiller P/E is 92.9% higher than the recorded historical mean of 16.9. That indicates an exceptionally high valuation of the stock market, which makes it comparable to levels that were recorded in 1929. The implied future annual returns of any new portfolio investments would be -3%.
Prof. Robert Shiller of Yale University invented the Shiller P/E to measure the market's valuation. This ratio is a more reasonable market valuation indicator than the P/E ratio because it eliminates fluctuations caused by the variation of profit margins during business cycles. This is comparable to market valuation based on the ratio of total market cap over GDP, where the variation of profit margins does not play a role either.
Using the Shiller method the valuation of an investor can be expected to drop over 43% in the value of a portfolio during a recession.
The projected drops in the valuation of an investor's portfolio can be overlooked if the stock market recovers and restores its worth. Whether a retired investor, who depends on monthly income from his portfolio, can bet on future a cyclical recoveries in stock prices is questionable. The last recovery cycle depended on massive injections of debt to restore stock prices. In the future that may not be possible. Federal debt is now greater than the Gross National Product (GDP) and cannot refinance tens of $ trillions except through devaluation of the dollar currency. Any recovered portfolio would be worth less than what is needed to support a retiree's income.
The current overvaluations of the stock market is also the result of inflating corporate earnings. That resulted in a rising government deficit. Such future injections of new corporate earnings into the stock market are not likely to be repeated.
When a recession occurs that will be signalled by a rise in interest costs. The best protection against a sudden decrease in a retiree's portfolio could be to shift from a dependency on equity to increase reliance on inflation-adjusted income from debt and dividends.