MB, Thread,
I'm linking below an article Mike Magner mentioned earlier on this thread. I think it's important enough to ask everyone to read it.
It's John Hussman's February Outlook. His January Outlook, btw, is outstanding as well - another must read.
Since he's an economist, it may take a couple of reads through for it all to sink in. This is a "Galileo" article. If you read this, and continue to be bullish on equities - no, let me restate this - if you're not PROFOUNDLY bearish on equities, your analysis of the available data is purely based on your faith, and wholly disconnected from the reality of that data.
And, if so, remember, they put Galileo in jail, they got him to recant, but they couldn't get the sun to rotate around the earth. All the analysts and pundits and policymakers on Wall Street and in DC can't change these facts. <ng>
Peter
concentric.net
Market Outlook
February 1999
The stock market is fairly valued. Fairly, that is, so long as investors
are willing to accept long-term total returns of 6.9% annually for the
indefinite future, and the S&P 500 price/earnings ratio stays at its
current extreme of 33 forever, and earnings climb along the peak of
their long- term growth channel. Earnings have remained in a
well-defined growth channel of 5.7% annually since 1950 (and even that
5.7% growth was achieved through higher rates of inflation and GDP
growth than observed at present). If the P/E can remain fixed at current
extremes while earnings climb, prices will grow at exactly the same 5.7%
rate as earnings. That 5.7% capital gain plus 1.2% dividend income means
that stocks are priced for a long-term total return of 6.9%. That is, if
stocks are fairly valued here. If not, look out below. Stocks have
achieved current extremes not primarily through earnings growth but
through an expansion in price/earnings multiples. They have achieved
high past returns by lowering the level of future returns. The law of
securities pricing is simple: prices move inversely to future returns.
If investors demand a higher return they get it by paying a lower price.
Bond investors know this. Stock market investors have forgotten this
lesson. Not for long.
S&P 500 EARNINGS 1950-Present : 5.7% GROWTH CHANNEL
[for this chart, check the website link above]
A "new era" article appeared in the Wall Street Journal on January 11th,
titled "Overvalued? Stocks' Price is Finally Right". (link) The article
goes on to explain an economist's conjecture that the market was
actually undervalued over the entire past century, and now that we have
learned more about return and risk, investors have finally driven prices
to their deserved levels. I was immediately reminded of the famous
economist Irving Fisher, who gushed that stocks had evidently reached "a
permanently high plateau". He made history by gushing said remark in
August 1929.
While the article suggests that the growth rate of earnings has
increased in recent years, the data suggest otherwise. The more rapid
growth of earnings in recent years represents a move from
trough-to-peak, rather than an increase in the long term peak-to-peak or
trough-to-trough rate of growth. Moreover, the correlation that the
author suggests between P/E ratios and subsequent earnings growth is an
artifact of earnings volatility. When earnings are depressed due to a
recession, this tends to result in a higher P/E ratio and higher
subsequent earnings growth, as earnings recover to pre-recession levels
(i.e. trough to peak). But as we have repeatedly noted, the proper way
to measure a market P/E is to use peak earnings over the prior 10 years
or so, which filters out uninformative swings in earnings due to
recession, and gives a better measure of actual earning power. Once this
is done, the spurious correlation between P/E ratios and subsequent
earnings growth vanishes, and the P/E becomes a purer measure of va
luation. What is striking is that even with this adjustment, the current
Price/Record-Earnings ratio is 31, compared to extremes of 20 seen only
at the 1929, 1972 and 1987 pre-crash peaks.
As noted above, if the market is indeed "fairly valued" here, it follows
that investors had better be willing to hold stocks for a long-term rate
of return of just 6.9% in the indefinite future. To say that a security
is "fairly valued on a historical basis" means that the long- term
return offered by that security is the same as its historical average.
To say that a security is "fairly valued relative to other securities"
means that, given the yields on other competing securities, the security
offers the level of long-term return required by investors. Typically,
investors have required a long-term return on stocks about 3-4% higher
than that available on bonds, sometimes more.
If, given current interest rates and competing yields, the long-term
return required by stock market investors has indeed fallen to 6.9%, we
would agree completely that stocks are fairly valued. But our impression
is that investors really are not willing to hold stocks at a 6.9% long
term rate of return. Indeed, we think that eventually, investors will
require a long-term rate of return in excess of 9% in order to induce
them to hold stocks. Even at current interest rates, a 9% required
return on equities would be a conservative expectation. If that happens,
hold onto your hat. In order to offer investors a long-term return of 9%
today, stock prices would have to fall by 60%.
A quick review of securities pricing, by way of example. Suppose you
hold a 30-year zero coupon bond which will pay $100 at maturity. The
price of the zero coupon bond is $100 / (1+i)T, where i is the yield to
maturity and T is the number of years to maturity. If the bond is
currently priced to yield 12% annually until maturity, the price of the
bond will be just $3.34 (which tells you something about the power of
sustained, long-term compounding even at 12%). Suppose that you hold the
bond for the first 10 years, and during that period, the yield on the
bond falls to just 7%. With 20 years remaining on the bond, the price
will be $25.84.
Notice something important. You have held the bond for 10 years, during
which time the price has increased from $3.34 to $25.84. The bond has
delivered a remarkable 22.7% annual return over that 10 year holding
period and yet, the yield-to-maturity neither began nor ended anywhere
near that level. The yield-to-maturity began at 12%, and fell to 7%. An
investor buying the bond today, and holding to maturity, will not earn
22.7% annually or even 12%. The investor will earn the 7%
yield-to-maturity which the bond is now priced to deliver. While
short-term fluctuations in the yield-to-maturity will lead to short term
fluctuations in returns, the long-term rate of return is essentially
known in advance.
Here is the crucial point: the same rule applies for stocks. True, bond
payments are fixed, while stock earnings are variable. The main way that
changes our analysis is that we have to distinguish between price gains
that go hand-in-hand with earnings growth, and price gains that emerge
from changes in valuations (such as P/E multiples). When we talk about
the long-term we observe remarkably little variation in the trend of
earnings growth, particularly when measured from peak- to-peak or
trough-to-trough. The chart above makes this point crystal clear. The
major source of variation in the long-term return on stocks is variation
in the P/E multiple, not variation in the earnings growth rate.
When the long-term rate of return on a security falls, the temporary
short-term returns can be fantastically high. But it is insanity to
extrapolate those fantastic short term returns into the future. A lower
long-term rate of return on stocks means that past returns have been
great, but it can only mean one thing for future long-term returns: that
they will be lower. He who does not open his eyes must open his wallet.
Were stocks ever priced for a long-term return of even 12% annually?
Yes. At the 1982 market bottom, the dividend yield on the S&P 500 Index
reached 6.7% and the P/E on the S&P 500 Index fell as low as 7. With
post-war earnings growth averaging 5.7% annually, an investor could
calculate that even if P/E ratios and dividend yields remained constant,
prices would grow at the same rate as earnings. Add the 5.7% earnings
growth rate to the 6.7% dividend yield, and stocks were priced for a
long-term total return of fully 12.4%. And this without requiring any
improvement in valuation multiples! An investor could also rationally
speculate (as opposed to "gambling") that valuation multiples would
indeed improve at some point, so that capital gains would be accelerated
by an expanding P/E ratio. Remember Price = Earnings x Price/Earnings.
Prices grow fastest when both components are increasing. In short, the
1982 low should have been viewed as a wild-eyed buy-o-rama. Instead,
investors were frantically abandoning stocks during a fully recognized
recession. They ignored the probably stellar future returns and instead
based their investment decisions on dismal past returns.
Fast-forward to 1999. The identical calculations imply that stocks are
now priced for a long-term total return of 6.9% annually. And this
without allowing any deterioration in valuation multiples! An investor
can also rationally speculate that valuation multiples will indeed
deteriorate at some point, so that capital gains will be restrained by a
declining P/E ratio. In short, the 1999 high should be viewed as a
wild-eyed sell-o-rama. Instead, investors are frantically buying stocks
during a fully recognized expansion. They are ignoring the probably
dismal future returns and instead base their investment decisions on
stellar past returns. |
