Reynolds wrote:
>I have read that the historical norm for real interest rates is,
>roughly, 1/2% to 1% at the short end and 1-1/2% to 2% at the long >end. Inflation is currently 1% to 1-1/2%, making real rates 4% to >4-1/2%. If the Market is not sufficiently pricing in risk, as Alan >Greenspan says, how high should they be? If real interest rates >return to historical norms, wouldn't that more than justify real >earnings yields of 6% to 7% (which, as you know, is the norm for the >real earnings yield, the norm for inflation being 3%)?
The historical record for real rates on the long end is somewhat distorted. This is something that I only learned a few years ago.
Earlier in this century, the government effectively managed interest rates in the bond market. Bonds were basically certificates of confiscation. After the late 60's and especially after 1972 (the gold standard completely dropped) real rates rose dramatically. Since then, real rates have averaged in the 4%-4.5% range. Pretty much in line with where they are now. The real rate however is not always in line with the current inflation rate. It is in line with long term inflation expectations. It is my opinion that 1997 benefited from some extraordinary circumstances on the inflation front. 1998 may well benefit from the deflation in Asia. Longer term, I am much less sure about the 1.7% CPI we had last year when those one time circumstances like the super strong dollar and Asia are not keeping a lid on inflation and import prices.
As to the earnings yield, a 6%-7% is very average. I certainly have no problem with numbers like that. In fact, if your personal assessment of inflation turns out to be correct and I am worried about demons past, I have no problem with 5%-6% earnings yields.
Unfortunately the S&P500 is currently trading at 27.5x trailing earnings. That's a 3.6% yield. This is looney based on the historical record.
On the Return on Equity front: ROE is presently a shade over 21%. The long term average is about 13%. It has been higher in the recent decade for some reasons that I can explain and for some reasons I have theories about. This scares me most of all and apparently has Buffett a little worried also. Let's just say that ROE returns to 15% and PE's return to 15. That would be the normalized level.
A 15% ROE on the S&P (I don't know the yearend 97 book value yet. It hasn't been published) would produce earnings of around $30.
30 X 15 = 450. The S&P500 is trading at 1100. That is a massive drop just to get to the mean. You also know all my overstated earnings arguments which could add to the pain.
Suppose things got bad as they have on numerous occasions this century and ROE went to 10% (is has on many occasions) and PE's dropped to 10 (they have on many occasions) That is 200 on the S&P500. I am certainly not predicting that sort of thing. It is probably a 2 or 3 time a century situation, but it is not impossible.
On the flip side ROE has never been this high and PEs have never been this high except when earnings were depressed.
That is why I am so bearish and cautious. This is the greatest bet on perfection in U.S history by far. God forbid the bulls are wrong....it will be a financial disaster for the American middle class. If they are right, gains will probably barely outstrip bonds over the next decade. It seems like a very very poor bet.
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