The recent spate of volatility in the global equity markets has caused some uproar amongst investors, but it really should come as no surprise. For the avoidance of doubt, we expect significantly more volatility and correction. Spoiler alert: We expect markets to fall another 30% or more before this correction is finished.
Conventional wisdom assumes markets are mostly unpredictable â€“ essentially just a coin flip. While this holds true for shorter periods, there is actually a very strong relationship between valuations and long term market returns. Unfortunately, the math is buried beneath so much volatility that few can unearth the real relationships.
This article outlines a simple model for market valuations and compares it to historical returns. There is still some volatility around the results, but the correlations are impressively high â€“ exceeding 0.90 for some metrics. After demonstrating their predictive power, we then put todayâ€™s elevated valuations into context. As the spoiler above indicates, markets are positioned for a very rough ride.
The last section of this article addresses a very relevant question: What to do with this knowledge? Timing markets and making sensible portfolio adjustments is a real challenge. For example, there can be significant tax consequences (i.e., capital gains) when rebalancing portfolios. Moreover, investorsâ€™ behavioral psychology make it very painful watching bubbles grow from the sidelines. Admittedly, we find the challenges so great in many situations that we find inaction is often the best course of action.