According to new research provided by Dr. John Hussman of the Hussman Funds, the market is very expensive and unlikely to attain long-term historical returns. Worse, in the best of circumstances, a 6.5% compound return over the next decade may be possible, but only in the most optimal situation.

Dr. Hussman’s research utilizes a methodology called peak-to-peak earnings to measure the stock market’s value. The methodology is somewhat simplistic and yet extremely useful in that the peak earnings of the S&P 500, once attained, continues to be used until a new peak is reached. This tends to smooth out P/E ratio calculations because price levels can be fairly compared even when earnings decrease significantly during a recession. In that situation, P/E ratios would skyrocket even if stock prices remained the same. Using peak-to-peak earnings allows one to forecast potential returns for the stock market (Dr. Hussman states that historical growth in earnings from one peak to the next has approximated 6% per year). Unfortunately, the P/E ratio today using peak to peak earnings is 20. Using the historical 6% growth rate in earnings over the next ten years, the following rates of return will be achieved if the following P/E ratios are attained:

Next 10-Year

20 P/E (Current) 6.5%

14 P/E (Historical Average) 4.0%

11 P/E (Historical Median) 2.5%

7 P/E (Historical Secular Bear Market Average Low P/E) -2.0%

Obviously, the above expected returns are unexciting, if not downright worrisome. Unfortunately, the lower return numbers are more likely because interest rates are rising. The Federal Reserve needs to raise interest rates another 2.50% (they have increased rates 2.00% so far) to attain historical norms. P/Es are negatively affected by rising interest rates and positively affected by declining interest rates. The last time we had both low interest rates and high P/Es was in the late 1960s. From the beginning of 1966 to the end of 1982, a 17-year period, the return on the stock market as measured by the S&P 500 underperformed inflation by approximately one-half of one percent for 17 years before taxes. Obviously, based upon the forecasted returns above, we expect the market to perform similarly to the 1966 to 1982 period once again.

How does an investor avoid this problematic situation? Simply minimize exposure in both bonds and U.S. stocks. Instead, investors should focus on total return strategies where portfolio managers of mutual funds or some other similar investment vehicle either have a great deal of latitude in selecting securities and asset classes to seek out opportunities for return or using hedging strategies to obtain return regardless of what the stock market does. In addition, such investments should have a low correlation (non-similar pattern of return) to one another which then creates a low volatility effect.

Investors should seek to avoid unnecessary risk where possible. By minimizing the downside, fantastic returns on the upside are not necessary to generate long-term competitive returns. In other words: avoid the roller coaster ride.