Preview

Here's how my thinking on the U.S. stock market has evolved over the last few years:

• Thinking about historical P/E ratios, November 8, 2006

"I see two options for how a stock market correction might play out: either a 1929-like stock market crash or a 1970s-like inflation cycle... I’d bet more on the latter although either scenario is possible. If the stock market keeps pushing up like it has in the last four months, a future crash might be more likely...

Corporate earnings dropped almost 50% from 1999 to 2001, but then rose almost 150% in the last four years. Have we had such a productivity revolution in this country that we can expect this kind of growth to continue? Can we think of any bubbles in the last four years that might have artificially driven up earnings? (think: housing!)

In no other time in history was a P/E level of over 20 sustainable. I’m betting this time is no different."

• The bleak outlook for the U.S. stock market, March 1, 2008

"Except for the peak of the Internet Bubble, today's stock market has the worst overall outlook in the last 60 years. The S&P 500 stock market index has the unfortunate combination of being at earnings and price-to-earnings ratio peaks at the same time...

Given the housing slowdown and the oncoming recession, I'd say it is quite likely that we are at a multi-year earnings peak...

Not only are stocks expensive relative to earnings, but the earnings themselves may be at the beginning of a major decline. That's a double-whammy to the downside for investors."

• The silent market crash, July 4, 2008

"Measured in dollars, the S&P 500 is down almost 15% since its 2000 highs. Adjusting for inflation or measuring with almost any other yardstick, the index is down substantially more.

This would be great if stocks were finally cheap again, but I don't see any evidence of that yet. When all is said and done, I expect the stock market to go quite a bit lower from its current level, not only in dollars but even more in terms of purchasing power."

• Is the U.S. stock market finally a good value?, October 17, 2008

"The big story for the stock market in 2009 will be the destruction of corporate earnings. If you believe (like I do) that a large fraction of corporate earnings in the past few years can be attributed to artificially rising home prices, then you might also be convinced that earnings could fall by as much as 50% from their peak around $82 per share in June 2007...

I would not yet call myself bullish on stocks, but at least I am no longer bearish. It's amazing how quickly things have changed in the last 6-12 months with the S&P 500 down 36% so far in 2008. I would not advise an overwhelming allocation to stocks, but adding to long-term stock market investments is worthwhile at this time."

So that's how we got here, now where are we going? In this issue, I review the U.S. stock market and try to make clearer the levels at which I would consider the U.S. stock market to be a good value.

On the whole, I reiterate my view that the stock market is priced to deliver adequate but not exceptional long-term returns. Consequently, I think being partially invested makes the most sense at this time.

Stock market earnings and valuation

Since I've focused so much on the earnings picture, let's start there. The best long-term stock market data can be found on the web site of Yale Economist Robert Shiller. All graphs below use these data, which are currently recorded through December 2008.

The two charts below display the S&P earnings over the last 140 years. First the nominal earnings:

Now adjusted for inflation:

According to Shiller's data, S&P 500 earnings are down nearly 70% from the peak in June 2007. I don't want to put too much emphasis on the exact numerical trends (I'll do that in a second), but I do want to make the point that earnings tend to be volatile in the short-run but more consistent in the long-run, especially in the last 70 years.

My personal guess is that December 2008 will be close to the trough of S&P 500 earnings. Maybe we go lower, maybe not, but the more relevant question for stock market valuation is what we expect for the next 5-10 years. Importantly: are we still in the high earnings growth channel of the last 70 years? Or will we experience a 15-year period (another Great Depression) of little or no earnings growth?

In other words, are we in Scenario 1 (No Great Depression)?

Or Scenario 2 (Great Depression)?

The earnings channel in December 2018 is $70-170 under Scenario 1 and $35-85 under Scenario 2. For valuation purposes, let's tighten the ranges to $110-130 and $55-65 and assume that: (1) dividends grow at roughly 4% per year and (2) the terminal price-to-earnings ratio is somewhere between 12 and 18. Results are sensitive to (2) but not (1). For each scenario, a 'Low' outcome is the lower earnings number and terminal P/E and a 'High' outcome is the higher earnings and terminal P/E.

Based on a market price of $735 (closing price on February 27, 2009), the S&P 500 will return 8.3-14.0% annually under Scenario 1 (No Great Depression) and 2.0-7.2% annually under Scenario 2 (Great Depression). If we're somewhere in between, expected returns aren't bad.

Here are 10-year annualized return estimates using a variety of purchase prices:

These estimates are imprecise. But they give you a sense for how your world outlook might translate into an investment return.

Two key assumptions drive the above methodology: (1) earnings tend to be cyclical in the short-run but consistent in the long-run and (2) investors tend to overpay when past earnings have been strong and underpay when past earnings have been weak. This is by no means a complete theory of the stock market, but these two basic rules guide my overall strategy for stock market investing. The calculations were useful, at least, for recognizing the overvalued market in 2007.

If you believe in the strict interpretation of the Efficient Market Hypothesis, you will probably not find the above exercise convincing.

A bit of irony: stock market bears claim that we are headed for another Great Depression. I suppose they are eager to buy stocks at some level (perhaps below $500 per share for the S&P 500). But returns under a Great Depression scenario are average at best, even after buying with such a substantial discount.

The ''danger'' scenario is that you buy stocks with an optimistic outlook and we enter a Great Depression. Returns are unlikely to be devastating at today's prices, but you will likely miss opportunities elsewhere for your investment capital.

Personally, I do not believe we are headed for a Great Depression. But I respect the possibility that earnings growth may be slower than normal in the next 5-10 years. This certainly feels like a deep recession, but I haven't lived through enough of them to develop a strong intuition. My best guess: put me down for 80/20 towards No Great Depression.

A mixed investment strategy

I wrote in my January 2009 Newsletter that a mixed investment outlook calls for a mixed investment strategy. We are not at a market extreme (high or low) like we were 18 months ago. Depending on your outlook for the macroeconomy, you should probably view the stock market as fairly valued (No Great Depression) or expensive (Great Depression).

But if you don't know for sure, it makes the most sense to be partially invested. The correct mix will depend on the individual. A poor strategy would be to wait for the market to go up by 50% before confirming to yourself that we are not in a depression. Buy some now, and buy more if valuations improve. I am not willing to be "all-in" at current levels, but nor am I willing to be "all-out".

If you are currently "all-out", what will you do if the stock market goes up from here? Will you buy at a higher level (not recommended)? Are you willing to hold your cash/gold/whatever for another 6 years? Maybe so, but you should have a clear reason for wanting to stay so liquid and uninvested (maybe to buy distressed real estate?).

Trying to time the bottom is fun. It is also potentially profitable for some investors. For most investors, I think this is a difficult strategy to implement (i.e. to be "all-out" until the bottom, at which point you go "all-in"). The more prudent strategy is to scale in as valuations improve.

As I noted in my March 2008 Newsletter, a complete 9-year bear market from 2000-2009 would be short relative to historical norms. I don't mean to be dogmatic about "bull markets" versus "bear markets" - clearly there is a lot of variation in between - but it's easy to conceptualize long-term stock market cycles in this way. My guess is that a long-term bear market low as in 1942 or 1980 is still a few years off. But it's possible that it comes in the next 12 months. You want to have at least some reserves in case it does.

[Editor's Note: added on March 4, 2009

One other long-term valuation methodology to consider is the price divided by the 10-year moving average of earnings (which is less sensitive to short-run earnings fluctuations):

By this metric, today's market valuation is not overly expensive as in 1901, 1929, 1965, or 2000, but nor is it excessively cheap as in 1921, 1931, 1942, or 1982. In fact, today's market is not far from the historical average. Probably we will see a major bear market low sometime in the next 5-10 years, at which point it makes sense to go "all-in". But a successful investment strategy should take into account that we might not get there in this market cycle.

The scatterplot below from Wikimedia Commons based on research by Yale Economist Robert Shiller provides some intuition for how well the 10-year price to earnings ratio has historically predicted future stock market returns.

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Conclusion

I don't believe that we are at a market extreme where the investment strategy is obvious. Value-oriented investors will probably enjoy stock picking in the current environment. Cycle-oriented investors will probably continue to hold at least some cash/gold with the expectation of a deeper bear market low in the future. Real estate investors will probably start buying more homes and buildings as home prices continue to fall.

As for me, I'm somewhat interested in all of the above, so I have a mixed strategy. Buy some stocks at this level, but otherwise stay liquid and build reserves to take advantage of possible stock market and real estate bargains in the future.