Stocks for the “Long Run”

We have sympathetically mentioned Jeremy Siegel’s well-timed Stocks for the Long Run in previous commentaries, whose analysis begins at very low PEs and ends most periods with much higher PEs, reaching the unforeseen conclusion that stocks outperform all other asset classes in “the long run”.  Similarly, a few days before the stock market crash of 1929, the leading economist of the time, Irving Fisher, ensured Americans that stock prices had reached what looked like a “permanently high plateau.”  And Jeremy Grantham recently reminded us of E.L. Smith’s Common Stocks as Long Term Investments, published in 1924. 

As Grantham so eloquently stated, There is always someone of the “Dow 36,000” persuasion to reinforce our need to believe that as markets decline, higher prices in previous peaks must surely have meant something, and not merely have been unjustified bubbly bursts of enthusiasm and momentum. 

And as much as we’d like to believe the same, history tells us that truth could not be further from Dow 36,000!! In the latest Investment Outlook from Bill Gross, PIMCOs Bond King appropriately warns that “one must be careful of beginning and ending data points in any theoretical ‘proof’”. As they say Professor Siegel, the theoretical proof is in the pudding.  Contrary to popular belief, drum roll please, starting valuations matter and remain the single largest determinant of expected long term returns. 

Price to Avg 10 Year Earnings

Source: Ned Davis Research

The chart above clearly demonstrates that today’s market is no longer cheap, and quite obviously overvalued based on cyclically adjusted earnings.  In fact, at nearly 20x Average 10-Year Earnings, the S&P 500 is not far from the most expensive quintile of valuation experienced since 1881, which has historically returned just 2.8% annually over the following ten years!! 

But clearly the world is not that black and white.  So let’s briefly revisit the Bond King’s observations regarding starting and ending points, because most of “the street” would much rather tell us a story with a happy ending.  With one stroke of Goldman’s magic wand, we can wipe out the first fifty years of data that Yale’s Robert Shiller took the time to analyze and reach the conclusion that stocks are marvelously cheap even after a 62.3% rip off the March lows to October highs!! 

GS PE ratio

Source: Goldman Sachs

 

We wonder why anyone would want their clients to believe this market is cheap when it is so clearly overvalued based on historical data?  Perhaps that’s a question that is better addressed in Goldman Trading Huddles.  In the meantime, we will continue to focus on observable conditions and take our evidence as it comes.  And right now, it is difficult for us to imagine that a market that traded substantially greater than one standard deviation above long term trend for most of the last decade (see below), will simply bounce back to these extremes and hover at inflated valuations, going forward.  Indeed, given the likelihood of increasing regulation, increasing government intervention, increasing public spending, increasing taxes, and ongoing private sector deleveraging, the more likely outcome is an extended period of below trend valuations.  So before getting too excited about The Wizard of Wharton’s Stocks for the Long Run, investors would be wise to revisit Professor Shiller’s Irrational Exuberance.  

Schiller PE

Source: Gluskin Sheff