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As the CAPE breaches 30, remember the Iron Law of Valuation

The 2015 global sell-off saw many equity markets fall over 20% and a crash in junk bonds. Developed and even European markets were priced to deliver double digit 12-year returns by the start of 2016, and investor sentiment was pessimistic. The energy and mining industries were in collapse. There was blood in the streets everywhere but the US equity market, which still sported a high but not outrageous Shiller PE of 24 and was priced to deliver 2-3% returns over the coming 12 years according to the most historically reliable valuation metrics.

2015 could have well marked the top of this bull market, but chaotic randomness dominates market action as time horizons shrink, such that no indicators are reliable on any time frame shorter than several years, with 10-15 years being the sweet spot for the correlation of future returns and present valuations. Thus the god of market mechanics has wrought a spectacular rebound in risk appetite, imbuing the multitudes with a fervor for indexing and devotion to a particularly orthodox strain of efficient market theory. They are committing a grave mistake to forsake the Iron Law of Valuation, and their pain will be half again greater.

The Iron Law of Valuation is that every security is a claim on an expected stream of future cash flows, and given that expected stream of future cash flows, the current price of the security moves opposite to the expected future return on that security. Particularly at market peaks, investors seem to believe that regardless of the extent of the preceding advance, future returns remain entirely unaffected. The repeated eagerness of investors to extrapolate returns and ignore the Iron Law of Valuation has been the source of the deepest losses in history.

There is nothing to be done for the mass of men, as a diminution in aggregate account values is assured. One can only save oneself, but to do that one must discover the Law and know that it is true.

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