The Long-Term Case for Stocks
Stocks have greater value than at any time during the past quarter century.
It may take a few years, but that value is likely to produce excellent returns
for investors with a long-term horizon.
This is the first of a two-part examination of current market conditions and a
comparison to 30 years ago.
Relative Real Value Is What Is Important ? But We Start with the Simple
It is frequently noted that basic stock valuation measures are near historical
levels. This is true. Here is a chart of the S&P 500 price/earnings
(P/E) ratio over the past quarter century.
It is unfortunate that stock valuations are typically presented via the P/E.
It is a valid measure, but it is not intuitively clear what it represents.
A much better way to think of stock valuations is simply the inverse -- the
earnings ratio (E/P). It is the exact same measure, but the earnings yield has
clearly understandable implications.
Here is the E/P chart for the past quarter century.
Stocks presently yield over 7% based on projected 2011 earnings. Again,
this is reasonably consistent with historical norms.
The analysis continues with what is one of the most stunning charts of the past
quarter century. Below is the year-over-year core rate of inflation.
Inflation has declined steadily and is at extremely low levels.
It is not surprising that, given this inflation trend, the yield on the 10-year
note has also trended lower during this period.
The Real Yield on Stocks and Bonds.
The historical earnings yield of E/P (or P/E) on stocks has no more meaning than
the historical yield on bonds without including the impact of inflation.
Subtracting the inflation rate from the stock or bond yield produces the
economically relevant "real" yield.
The real, inflation adjusted, yields on earnings and the 10-year Treasury note
are presented below.
Assessing where to put money is critical to sound, real-world investing.
Investing in the proper asset class -- stocks, bonds, or cash -- is the most
important aspect of achieving good investment returns.
One of the most important analyses in investing is therefore how stock
valuations compare to bond valuations.
This is where it becomes apparent that stock valuations are appealing.
Below is a chart of real stock yields minus real 10-year Treasury note yields.
A positive value means that stocks provide a greater real return than bonds.
As can be seen, the real return on stocks approximated the real return on
bonds from about 1985 through 1999. During this period, which included
many of the Greenspan Fed years, there was much talk about the "Fed model" for
stock valuation. That model proposed that the forward twelve-month yield
on stocks should approximate the 10-year Treasury yield.
It is imprecise but not a bad starting point and worked well for over a decade
Then in 1999 and 2000 stock values rose sharply and the real yield on stocks
dropped below bonds. This analysis suggested that stocks represented poor
relative value. Stocks subsequently crashed.
From 2002 through 2007 stocks seemingly provided better relative yields than
bonds, and of course for a while stocks ran strong. This proved a false
valuation signal, however, as the economy and the market encountered what was
(literally) a once-in-a-generation credit crisis. This produced the stock
market crash of 2008. (This may well prove an aberration separate from normal
business cycles which will not recur for many decades.)
The decline in stock values in 2008, however, also pushed the relative value of
stocks to amazing levels not seen during your author's increasingly long career
in the financial markets.
The S&P 500 is up 100% over the two years since stock valuations spiked higher
as seen in the chart above.
The unusually large difference in stock yields relative to bond yields,
sometimes called the risk premium, reflected fears prevalent throughout the
investment world in 2008. Those fears were built into stock prices, but
precisely for that reason, produced what in hindsight was a once-in-a-lifetime
The relative valuation opportunity in stocks has declined the past two years
given the recent huge stock market rally but nevertheless remains extremely high
on a historical basis.
In fact, given the decline in risk in the economic and earnings outlook the past
year, the reward/risk ratio is arguably better now than it was in 2009 when risk
The relative value in stocks is striking to your current author, who has been in
the financial markets for over 30 years. It reminds me of the situation in
1979 when I first entered the financial markets.
In 1979, everyone knew that stocks were a terrible investment. After all,
stocks had produced no gains over the prior 14 years! My stock broker
insisted in the early 1980s, however, that it was a "turkey shoot" for stocks.
I stuck with safer money market yields instead. The Dow was at 815 my first
month of employment.
Everyone today also knows that stocks are a lousy investment. The Dow is
right where it was 12 years ago! Young investors today have witnessed the
crash of 2000-2001 and 2008. Everyone knows that stocks are far too risky
for the lousy returns offered.
That could continue to be true. On the other hand, the relative value that
exists in stocks today could well produce solid returns over the long term,
particularly compared to bonds or cash. The current high earnings yield
relative to inflation and bonds will, as risks ease, decline, and produce good
returns in stocks relative to other asset classes.
Below is an interesting long-term chart of the Dow. The numbers below the
yearly trend reflect a compounded annual growth rate.
The chart suggests that there may be generational cycles that impact
long-term stock trends.
It also suggests that it may be a few years before a bull market returns.
That seems very reasonable.
It may take a few more years for the credit markets to fully clear and for
credit expansion to develop. It may take a few years for the housing market to
fully stabilize. It will also certainly take some time to address the imbalances
in governmental balance sheets that the country faces.
Nevertheless, the history of the US and free market economies in democracies is
that economic problems are addressed and that markets self-correct.
Given current conditions, it may be very hard for many that have experienced
just the past decade of the financial markets to believe that another bull run
will ever recur in the stock market.
That is exactly what I thought in 1979 when I first entered the financial
markets. The stock market had been flat for 14 years and everyone absolutely
knew, beyond any doubt, that stocks were a lousy investment.
That proved wrong, as did almost every single aspect of conventional wisdom from
those bleak days.
Now may be exactly the right time for long-term investors to start accumulating
stock positions, just as it was in 1979.
The next Big Picture column to be published in two weeks will continue long-term
considerations with a retrospective on the changes that have occurred over the
past 30 years and what that might imply for long-term investing today.