Today's WSJ has an article by the same author I cited last week:
Are Stocks
Overvalued?
Not a Chance
By JAMES K. GLASSMAN and KEVIN A. HASSETT
The Dow Jones Industrial Average has returned more than 200% over the
past five years, and the past three have set an all-time record. So it's hardly
surprising that many observers worry the stock market is overvalued. One
of the most popular measures of valuation, the ratio of a stock's price to its
earnings per share (P/E) is close to an all-time high. The P/E of the average
stock on the Dow is 22.5, meaning that it costs $22.50 to buy $1 in
profits--or, conversely, that an investor's return (earnings divided by price)
is just 4.4%, vs. 5.9% for long-term Treasury bonds.
Yet Warren Buffett, chairman of Berkshire Hathaway Corp. and the most
successful large-scale investor of our time, told shareholders in a March 14
letter that "there is no reason to think of stocks as generally overvalued" as
long as interest rates remain low and businesses continue to operate as
profitably as they have in recent years. Investors were buoyed by this
statement, even though Mr. Buffett provided no analysis to back up his
assertion.
Widespread Misunderstanding
Mr. Buffett is right--and we have the numbers and the theory to back him
up. Worries about overvaluation, we believe, are based on a serious and
widespread misunderstanding of the returns and risks associated with
equities. We are not so foolish as to predict the short-term course of
stocks, but we are not reluctant to state that, based on modest assumptions
about interest rates and profit levels, current P/E levels give us no great
concern--nor would levels as much as twice as high.
The fact is that if you hold stocks instead of bonds the amount of money
flowing into your pockets will be higher over time. Why? Both bonds and
stocks provide their owners with a flow of cash over time. For bonds, the
arithmetic is simple: If you buy a $10,000 bond paying 6% interest today,
you'll receive $600 every year. For equities, the math is more complicated:
Assume that a stock currently yields 2%, or $2 for each share priced at
$100. Say you own 100 shares; total dividend payments are $200--much
lower than for bonds.
But wait. There is a big difference. Profits grow over time. If that dividend
should increase with profits, say at a rate of 5% annually, then, by the 30th
year, your annual dividend payment will be over $800, or one-third more
than the bond is yielding. The price of the stock almost certainly will have
risen as well.
By this simple exercise, we can see that stocks--even with their profits
growing at a moderate 5%--will return far more than bonds over long
periods. Over the past 70 years, stocks have annually returned 4.8
percentage points more than long-term U.S. Treasury bonds and 6.8 points
more than Treasury bills, according to Ibbotson Associates Inc., a Chicago
research firm.
But isn't that extra reward--what economists call the "equity
premium"--merely the bonus paid by the market to investors who accept
higher risk, since returns for stocks are so much more uncertain than for
bonds? To this question, we respond: What extra risk?
In his book "Stocks for the Long Run," Jeremy J. Siegel of the University of
Pennsylvania concludes: "It is widely known that stock returns, on average,
exceed bonds in the long run. But it is little known that in the long run, the
risks in stocks are less than those found in bonds or even bills!" Mr. Siegel
looked at every 20-year holding period from 1802 to 1992 and found that
the worst real return for stocks was an annual average of 1.2% and the best
was an annual average of 12.6%. For long-term bonds, the range was
minus 3.1% to plus 8.8%; for T-bills, minus 3.0% to plus 8.3%.
Based on these findings, it would seem that there should be no need for an
equity risk premium at all--and that the correct valuation for the stock
market would be one that equalizes the present value of cash flow between
stocks and bonds in the long run. Think of the market as offering you two
assets, one that will pay you $1,000 over the next 30 years in a steady
stream and another that, just as surely, will pay you the $1,000, but the cash
flow will vary from year to year. Assuming you're investing for the long
term, you will value them about the same.
What valuation level of the stock market would equalize the income flow
from stocks and bonds? To keep the calculations simple, we will pretend
that you can buy a perpetuity (an annuity that lasts forever) that pays
5.9%--about the current long-term T-bond rate. Assume that the flow of
payments you receive when you buy a stock is also a perpetuity. Also
assume that after-tax earnings are a reasonable estimate of the cash flow
from a stock, that future inflation will be 2.8% annually, and that real
earnings will grow at the same rate as the rest of the economy, 2.1% a year.
(Currently inflation is far lower and growth far higher, but we're using the
long-run assumptions of the Congressional Budget Office.)
Using a simple and accepted formula, we find that the P/E that would
equalize the present value of the cash flow from stocks and bonds is about
100. By this measure, the stock market is undervalued by a factor of about
four. At current prices, the flow of cash associated with holding stocks for
many years is four times as high as that for bonds.
Does that mean the Dow ought to be at 35000 instead of 8800? Not quite.
There are three important qualifications. First, the present-value calculations
will change a great deal if the real growth-rate assumptions change only a
little. If growth falls even a little short, the cash flow from stocks and bonds
looks more similar.
Second, we assumed that there was no risk premium at all in the long run,
as Mr. Siegel's research shows. But that may overstate the case. For the
premium to vanish, investors must hold their shares in a diversified portfolio
for at least 20 years. In practice, investors often waver. A sensible question,
therefore, would be: How would our calculations change if we introduced a
risk premium, which would increase the rate at which you discount
expected future cash flows? As it turns out, a fairly modest risk premium of
about 3% would imply that the market is currently valued correctly. Again,
however, that premium is higher than history indicates it should be.
Finally, earnings might not be the best measure of the cash flow associated
with holding a stock. Suppose, for example, firms are retaining lots of
money today because they anticipate having to make big capital
expenditures in the future in order to maintain growth. It may be that
dividends are a better measure, and dividends are much lower than
earnings. Dividends are probably an underestimate of the cash flow, since
many big profitable companies, such as Microsoft, pay none at all. But
making the same growth and inflation assumptions as before, a payout of
merely 1% would equalize the present value of cash flow from holding
stocks with that currently received by bondholders. The Dow now yields
1.6%. Adding an estimate about the current level of share repurchases (the
equivalent of dividends) the total cash flow from firms to current
shareholders is probably about 2%. That means that even by the dividend
measure, the market is undervalued by about 50%.
Taking the Long View
Allow us now to suggest a hypothesis about the huge returns posted by the
stock market over the past few years: As mutual funds have advertised the
reduction of risk acquired by taking the long view, the risk premium
required by shareholders has gradually drifted down. Since Siegel's results
suggest that the correct risk premium might be zero, this drift
downward--and the corresponding trend toward higher stock prices--may
not be over.
In order for the risk premium to go all the way to zero, the market would
need to rise by between 100% (the dividend measure) and 340% (the
earnings measure). We wouldn't bet the ranch on such an enormous and
immediate increase. After all, subtle variations in parameters we cannot
possibly predict, such as the growth rate or inflation rate, lead to big
changes in conclusions. The cash flow between bonds and stocks would
also be equalized, for example, if the stock market stayed where it is and
the interest rate on long bonds climbed to about 9.5%. However, in the
current environment, we are very comfortable both in holding stocks and in
saying that pundits who claim the market is overvalued are foolish.
Mr. Glassman is a resident fellow and Mr. Hassett a resident scholar
at the American Enterprise Institute.
interactive2.wsj.com
The demographics and economics driving today's market are far far different than those that drove the "Nifty 50" era. Anyone that tries to make that analogy just proves that wisdom does not always come with age. And to drive home that point, sounds more like some are trying to justify having invested in the wrong networking companies. |
