Time to Rethink Stocks?

A recent column by Fortune writer Allan Sloan is ominously titled "Don't expect another bull market." In the article, Mr. Sloan argues that the period from 1982 through 2000 was an unrepeatable stock market party and it's going to lead to a lot of disappointment if investors are anchored too heavily to the returns from that time period.

To a large extent his argument holds -- taking numbers from Yahoo!Finance, I found that the S&P 500 increased around 15% per year between the beginning of 1982 and the start of 2000. This is a far cry from the 7.8% that I calculated for the period from January 1950 and January of this year. Of course the numbers that Mr. Sloan was looking at for his article -- and he does note this -- are fairly particular to the time period he chose. If we shift the range a bit, say, 1987 to 2008 or 1977 to 2008, the annual returns fall and are closer to the longer term average.

But it'd be nitpicky of me to lose the point in the details. The last 20 years have been very good for stocks and individual investors have found there way into the market in greater numbers. This may have led to some over-excitement in the markets and unsustainable valuations.

Yale economist Robert Shiller has collected data (which I've already visited) on the stock market going back as far as 1871 and has calculated the P/E of the stock market based on average 10-year trailing earnings for every month since then. Over the course of the last 100 years or so, this P/E number has spent most of its time ranging from the mid-single-digits to the low-20s. But in 1992, the P/E broke above 20 and made a mad dash to the mid-40s during the DotCom bubble. At the beginning of this year, Mr. Shiller's numbers show us at 24 -- safely down from the dizzying peaks of the DotCom days, but hardly low by historical standards.

So what's ahead? To Mr. Sloan's original point, investors that anticipate easily racking up 15% or greater annual returns may have to readjust their expectations. At the same time, it may be more important than ever that investors take valuation into consideration when making investment decisions. Investors have been reminded on numerous instances that valuation does matter (aside from the DotCom era there was always the Nifty Fifty).

-AvgJoe

The S&P's P/E Ratio

I'm reading The Intelligent Investor again. If you are interested in investing and haven't read this, you can pick it up for $14 from Amazon.com (click here). Don't worry, there's no kickback to me for that, I just think it's a great read that all investors should have at the top of their collection.

In one section of the book Graham gets into valuing the overall market. He looks at a number of metrics including price to prior year's earnings and price to prior 3-years' average earnings. In the commentary section (which Jason Zweig wrote) there is an additional look at more recent times (the book was published in 2003) and comparisons to the past using some data generated by Robert Shiller.

Not surprisingly, it inspired me to look at where we are today. Shiller's preferred metric is current S&P price versus average earnings over the prior ten years. His site shows us at a bit over 24x as of January. Looking back at his numbers (which go back to 1871), 24x isn't all that bad if you just look at post-1990, but it's still pretty heady if you consider it in the context of the entire history that Shiller has laid out. In fact, prior to 1990, the last time Shiller shows us at over 24x was in 1966, and the period from 1966 to 1980 was not too pretty for US equities.

Now if you flip to the tab that he has comparing P/E to interest rates (figure 1.3 at the bottom) it seems relatively obvious why we've held these higher-than-average earnings multiples -- low interest rates. I wouldn't give this chart the last word, but it shows P/E ratios and long term interest rates moving in fairly opposite directions. This is also something that jibes with theory.

But what happens when interest rates start moving back up?

After all, this credit mess isn't going to last forever, and when something happens to get us out of defcon 5, the Federal Reserve will have to get back to fighting inflation (much to many people's chagrin). I'm not expecting hyperinflation or anything like that, but 3% rates are hardly sustainable. And when that happens, we'll probably -- or we should at least -- see a contraction of P/E multiples.

I wouldn't argue that this means to stay out of US equities altogether. Particularly if you're Graham's classic defensive investor, investing on schedule is still the best idea (if you don't get that reference, see above and buy the book). Even if you're a bit more on the enterprising side, I don't think it means bail out completely.

What I do think it means is that investors should be avoiding stocks that are at the high end of the valuation scale. I know, I know, new and shocking info... As unexciting of a result as that might be, investors that aren't chasing high P/E momentum stocks when overall P/Es start to compress will have fewer wounds (if any) to lick than those that are caught with stocks sporting 40x and 50x multiples.

-AvgJoe

Hard Times

I couldn't help but call out this article from the AP if for no other reason than it was just so weird. While there are some interesting points in there, it is a bit rambling and doesn't seem to have a cohesive thesis.

But I'm not highlighting the article to perform an amateur literary critique. Rather, I found the premise, that there's this underlying discontentment in the US -- even during the good times -- pretty interesting.

A quote from the article:

The number of products -- from air conditioners to cell phones -- that Americans say they can't live without has grown substantially in recent years, according to the Pew Research Center. About 6 in 10 working Americans polled by the group say they don't earn enough to lead the life they want.

Not to veer too far from the premise of my blog, but are Americans realizing that the promises of advertisers didn't lead to the elusive stairway to heaven? Were we hoping for something from material wealth that it was never going to give us?

Obviously this isn't a philosophical blog, but when an article like that shows up on Yahoo!Finance's front page, well, I can't help but take note.

-AvgJoe

Wall Street Research

Interesting bit from TheDeal.com blog...

The blogs are taking over investment research! [shivers]

-AvgJoe

New NAR Data

The much maligned National Association of Realtors (NAR) just came out with its fourth quarter report on home sales and home prices. The title of the release was, well, true NAR style: "Metro Areas Show Greatly Mixed Home Price Performance; Half Show Gains."

It was the first paragraph, though, that really jumped out at me:

Roughly half of metropolitan areas continued to show rising home prices in the fourth quarter of 2007, according to the latest quarterly survey by the National Association of Realtors®.

Now of course I appreciate why they want to emphasize that some housing markets are still going up in price. And I'm sure the news has warmed the hearts of many a homeowner in these areas, but it still seems kind of funny to me that they're emphasizing rising prices. I guess it all goes back to the fact that so many Americans think of their home as an investment good rather than a consumption good, but still...

I already bought a house. I didn't get the deal because I didn't wait long enough (woe is me, I know), but I got a deal because I bought after the declines had already started. But the fact that home prices are falling in so many areas seems like good news for home shoppers. Or maybe my head's just screwed on backwards.

-AvgJoe

Fear and Loathing in the Markets

If you haven't seen it already, Paul Kedrosky today highlighted the recent survey of money managers from Merrill Lynch. In short, the survey said that managers are extremely bearish and expecting further declines in the equity markets. Cash is very popular right now -- Merrill mentioned that 41% of managers are overweight cash, the highest percentage since the terrorist attacks in 2001. In case it doesn't sink in right away, that means there's a lot of cash on the sidelines that needs to get invested at some point.

If you're keen on investing against prevailing sentiment, this is a pretty darn interesting data point.

It comes at an interesting point for me too. Just yesterday I was mulling over the risks that were out there and thinking about how very real the risks are. As I've previously stated, I don't think we're headed for financial disaster. However, I can't deny that the pieces are in place that could make that possible. So the risks are real.

Money managers aren't stupid. If the risks weren't real nobody would be worried and nobody would be selling. If it was obvious that this was all going to end well, or at least without fire and brimstone, then those 41% of managers would still be in equities. If only I could transport myself in time, I could head back to 2002, 1974, 1990, 1987, etc. and I'd likely see that the risks were just as real in all of those situations. Yet I'd jump at the opportunity to invest in any of those periods.

I'm not stupid either (at least I don't like to think of myself as such...), I can see why the problems are considered so dire. But as I take the range of potential outcomes and weight probabilities, I like the chances and the risk/reward that's out there right now.

-AvgJoe

For Whom the Bell Tolls

Now if this doesn't sum up the housing market mess in one fell swoop, then I don't know what does!

-AvgJoe