It is not only pictures but also numbers that can sometimes be worth a thousand words. A chart of the Standard & Poor’s 500, the world’s most widely followed stock index, shows it bouncing repeatedly between bouts of fear and greed last year in a 300 point or 24 per cent range – but winding up almost exactly where it started with a loss of a whopping four hundredths of one per cent.
Simply put, even with the index back to where it was 12 years ago, there are some awfully convincing reasons to fear the worst. After seeing not one but two bubbles pop in the intervening years, prophets of doom have gone from being treated as awkward crashers at a roaring party to the guests of honour. And, while the prerogative for most Wall Street talking heads is to be bullish about America, pounding the table without at least throwing in a caveat or explaining away the impact of the crisis in Europe or the fears of a hard landing in emerging markets is bad form.
But 12 years is 12 years. The economy, and with it corporate profits, have weathered two downturns and are higher today, leaving the trailing price-to-earnings ratio of the S&P 500 at a quite reasonable 13 times. In an ultra-low yield world, the index even yields more than benchmark 10 year Treasury notes.
The reply to the “stocks are cheap” argument – apart from citing dangers such as sovereign debt crises – is that strategists are falling into the same trap as the last time; missing the valuation forest for the trees. Using the methodology popularised by Yale professor Robert Shiller and basing the “E” on 10 years of average earnings to get a cyclically adjusted p/e (CAPE), the market is about 27 per cent more than the average since 1900.
Dr Shiller and his fellow sceptics certainly earned the benefit of the doubt last time round – but is it just possible that sentiment has swung a bit too far, to give Wall Street’s cheering section short shrift?
Consider, for example, the current CAPE of slightly more than 21 times. It is far from an extreme, being at the same level as January 1994 (not a bad time to have been invested in stocks) and half its January 2000 level. What is more, it might be overstating how dear stocks are because it uses a truly awful 10-year period to derive average earnings. The average of the last 10 years’ real (inflation-adjusted) earnings is less than 70 per cent of the trailing real earnings for the S&P 500. Back in 1994, when the CAPE was at the same level, the two figures were nearly identical. In other words, one of the favourite sanity checks for stock valuation may be subject to distortion.
Sceptics pooh-poohing the widely cited 13 times trailing and 12 times forward P/E ratio have a strong argument in favour of sticking to cyclically adjusted ratios, however. Unadjusted numbers are based on extraordinarily high corporate profitability – one of the most reliably mean-reverting numbers in finance. Operating margins for the S&P 500’s constituents were nearly 9 per cent last year whereas the average from 1997 through 2009 was less than 7 per cent. Apply the average margin to last year’s revenue and the trailing p/e rises to a tad pricey 16.7 times.
They say the four most dangerous words in investing are: “This time is different.” But strategists at Bank of America make a convincing case that margins may not revert entirely. The shift of sales abroad to lower tax jurisdictions, lower interest expense and the greater weight of higher margin technology shares have added 1.55 percentage points to net margins of non-financial S&P 500 constituents since 2004.
Even if all this is taken into account, US equities may be only somewhere at about fair price – certainly not the kind of value proposition that draws in fresh money when sovereign woes threaten to spill onto US shores. Indeed, retail investors largely have been net sellers of equity mutual funds and buyers of bond and hybrid funds in recent months.
In the end, US investors may have gotten it about right by paying no more for stocks than they did a year earlier. But the alternatives look lousy with US long bonds having returned 34 per cent last year and sporting after-tax yields below inflation. Cash will remain a dead zone for a while. It does not make for the most compelling sales pitch but, after being dead-in-the-water, stocks may have become the least bad place to park one’s savings.
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