Is the Stock Market Cheap?

[photoguy]

Here's a really interesting article discussing PE10 and some of it criticisms (and defenses) by Asness:

http://www.aqr.com/Portals/1/Researc...liffAsness.pdf

Some excerpts:

"Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker (best cases remain OK from any decile, so there is generally hope even if it should not triumph over experience!)."

"If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to playout again, and rooting for something drastically above the average case from these valuations."

"So why do some people dismiss today’s high Shiller P/E, saying it’s not a problem?... They point out that we had two serious earnings recessions recently (though only the tail end of the 2000-2002 event makes it into today’s Shiller P/E), including one that was a doozy following the 2008 financial crisis. They thus feel the final (the right end of the graph) strong earnings number is more relevant than that of the prior 10 years."

"Not surprisingly, if one compares one-year earnings to history, things look much rosier, though the stock market is still not cheap. Instead of a Shiller P/E that is in the 80th percentile versus history right now (expensive), the one-year P/E is in the 54th percentile since 1926 (trivially expensive)"

The last quote is one I think is critical -- basically a 60/40 portfolio can expect a real return of just 2.2%:

"To get the expected real return on stocks you invert the Shiller P/E to get an earnings yield. For bonds we compare 10- year nominal yields on Treasury Bonds to forecasted long-term inflation (here we use nothing fancier than trailing three- year inflation). Take 60% of the stock market number and 40% of the bond market number and you get the above graph, an estimate of the expected long-term forward looking real return on the whole 60/40 portfolio. Needless to say it’s now very low versus history (2.2% real as of September 30, 2012)."

[haha]

Quote:

Originally Posted by photoguy Here's a really interesting article discussing PE10 and some of it criticisms (and defenses) by Asness: http://www.aqr.com/Portals/1/Researc...liffAsness.pdf Some excerpts: "Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker (best cases remain OK from any decile, so there is generally hope even if it should not triumph over experience!)." "If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to playout again, and rooting for something drastically above the average case from these valuations." "So why do some people dismiss today’s high Shiller P/E, saying it’s not a problem?... They point out that we had two serious earnings recessions recently (though only the tail end of the 2000-2002 event makes it into today’s Shiller P/E), including one that was a doozy following the 2008 financial crisis. They thus feel the final (the right end of the graph) strong earnings number is more relevant than that of the prior 10 years." "Not surprisingly, if one compares one-year earnings to history, things look much rosier, though the stock market is still not cheap. Instead of a Shiller P/E that is in the 80th percentile versus history right now (expensive), the one-year P/E is in the 54th percentile since 1926 (trivially expensive)" The last quote is one I think is critical -- basically a 60/40 portfolio can expect a real return of just 2.2%: "To get the expected real return on stocks you invert the Shiller P/E to get an earnings yield. For bonds we compare 10- year nominal yields on Treasury Bonds to forecasted long-term inflation (here we use nothing fancier than trailing three- year inflation). Take 60% of the stock market number and 40% of the bond market number and you get the above graph, an estimate of the expected long-term forward looking real return on the whole 60/40 portfolio. Needless to say it’s now very low versus history (2.2% real as of September 30, 2012)."

This should not be a surprise to anyone. Yet it will have small effect on ER plans.

Ha

[clifp]

Quote:

Originally Posted by haha This should not be a surprise to anyone. Yet it will have small effect on ER plans. Ha

While it agree it not surprising and I also agree a not lot of retirement plans will change based on this info. I am curious assuming that you accept P/E 10 is decent forecasting tool for predicting future stock market returns.

What are you going do differently? Now perhaps you don't need to do anything because of age and portfolio size.

But lets say that you had just retired at 55 and you are depending on your portfolio to provide 1/2 your income (SS+ small government pension provide the rest.). You had planned on a 3.5% withdrawal rate and 60/40 portfolio.

Are you going to do anything differently know that the most likely real return of a 60/40 portfolio over the next decade is 2.2%?

[audreyh1]

Quote:

Originally Posted by Hamlet My problem with using PE/10 right now is the massive losses in 2009 distort the measure. Will stocks suddenly become more valuable in 2019 when that year falls off the PE/10 measurement?

Yeah - load up in 2019!!!

[audreyh1]

2.2% real return is good enough. It's the <1% real return that would worry me.

[Midpack]

Quote:

Originally Posted by audreyh1 2.2% real return is good enough. It's the <1% real return that would worry me.

+1. I've run all out plans on 0-2%, so 2.2% would be wonderful for us provided the sequence of returns isn't too crazy.

[MichaelB]

Quote:

Originally Posted by haha This should not be a surprise to anyone. Yet it will have small effect on ER plans. Ha

You may be right.

Quote:

Originally Posted by audreyh1 2.2% real return is good enough. It's the <1% real return that would worry me.

2.2% real return is not enough to satisfy a 4% withdrawal rate over 30 years. Using FIRECalc, plugging in the 2.2% rate and assuming a low rate of volatility (4% SD) it fails 1/3 of the time.

[haha]

Quote:

Originally Posted by clifp While it agree it not surprising and I also agree a not lot of retirement plans will change based on this info. I am curious assuming that you accept P/E 10 is decent forecasting tool for predicting future stock market returns. What are you going do differently? Now perhaps you don't need to do anything because of age and portfolio size. But lets say that you had just retired at 55 and you are depending on your portfolio to provide 1/2 your income (SS+ small government pension provide the rest.). You had planned on a 3.5% withdrawal rate and 60/40 portfolio. Are you going to do anything differently know that the most likely real return of a 60/40 portfolio over the next decade is 2.2%?

I agree it is a difficult situation. What I do, and have done, and likely will do in the future, is lean more toward market reflecting and higher volatility securities when PE10 appears to suggest a stronger return, and lower volatility securities or securities that are more likely to respond to other issues than S&P 500 movements when PE10 is high. Also, when interest rates are higher, I will go more into cash if it can be done with moderate or small ltcg cost.

Essentially, in a loose way my allocation is informed by the level of PE10. Incidentally, there are other valid long term market valuation tools that approach valuation from a different angle, but usually more or less in concert with PE10. One is described in Andrew Smithers' book, Valuing Wall Street.

Ha

[haha]

Quote:

Originally Posted by MichaelB You may be right. 2.2% real return is not enough to satisfy a 4% withdrawal rate over 30 years. Using FIRECalc, plugging in the 2.2% rate and assuming a low rate of volatility (4% SD) it fails 1/3 of the time.

What make this even more challenging is that low returns are usually a product of higher volatility, not lower.

IMO it is not a happy prospect.

Ha

[EvrClrx311]

Quote:

Originally Posted by haha I think you are conflating factual observations with interpretation of them. True, PE10 is what it is, and true that these levels do not suggest unusually high, or even average returns on S&P 500 over the longer term. And true that we are exiting a bad performance for over a decade. But IMO your idea that this suggests very good returns going forward is flawed. You can stand atop a 5000"foot mountain and with an overall elevation loss of 5000' you should be at sea level. But if you stand atop Mt Rainier and descend 5000', you still have a very long way to go. One could look at the 2000 top as Mt Rainier, or even Denali. Ha

Just trying to wrap my head around the trends. I definitely get that the future can deviate from the past, but the more past you include the less likely you are to see something new into the future. When looking back 150 years, every period of time where the market has performed as bad as it has the last decade, we've seen a very positive run in the market the next couple decades. What is also true is that in all those periods people thought times were different and stated a number of reasons why the market couldn't/wouldn't get back to its long term 10% yearly return trend.

Market tends to do the opposite of what people expect... particularly near its peaks ("bliss, this bubble will never burst") and troughs ("the economy has changed, we'll never get it back").

There is evidence to support both directions. I think more people are on the side of caution right now because all we've seen the last decade is wild volatility - next up is the drop.

Question is... when do we break this cycle and return to normal (on a historical scale)? On that 10.5% whole market trend we've seen historically... the DOW today would need to be around 40,500 to be as "dangerously" above the long term trend as it was in 2000 (that is what the 100+ year historical average 10.5% return on 11,700 in 2000 would be today). The lost decade... did it really fix anything? Doesn't appear it did, since we still think 15,000 is overpriced, and 40,500 seems looney to even fathom hitting this decade, or the next.

Inflation has a lot to do with this as well. Historically speaking, it has been very low for a while. If you wanted it to revert to it's long term mean you'd have to expect 4-6% levels for the next decade. That would certainly help fuel pushing stocks to double in value between now and 2023. Though the cost of everything would also go up 50-75%.

An interesting read from May of 2000 in Time magazine:
Will the DOW ever hit 50,000?

Quote:

HASSETT There is no question that if you run through history, Bob is right--that over some periods following peaks in the P/E, there were some bad times. My problem with that exercise is that if you took anything, any metric of how the market is doing, and calculated the average over time, then, of course, when you are above it, then you go down, and when you are below it, you go up. SHILLER Not necessarily, not with the P/E ratio. You are suggesting there is some spurious--some fallacy in that. There isn't a fallacy here. I look at past historical periods when we had similar leveling, and you know, what comes to mind is 1929. We have had a tripling of the stock market to a record high level in the past five years, and there is only one other time when that has happened, which was '24 to '29. So history doesn't encourage me to think people have suddenly learned something. GLASSMAN I just think people should know that in 1990 the Dow was at 2,600. In 1995 it [finished] at 5,100. Now, if you are Bob, you would say, "Whoa, we are about to have another crash like 1929." What has it done since the end of 1995? We are now, as we sit here, above 11,000 [the Dow closed at 10,609 last week], so I don't think it is predictive to say simply that if the Dow triples, it is going to crash. In the past 18 years, the Dow has risen by a factor of 14. What we're saying is that something profound is going on.

For what its worth, the DOW at 2,600 in 1990 growing at the long term 10% market trend would put us at 23,000 today (I always forget if the DOW figure includes reinvesting dividends, if not... that is misleading by comparison). If one really thought the 10% average return seen for the last 100 years is to hold up, we could assume the market is cheaper today than it was in 1990. Is 10% the magic number? Or should it be 9%, or 8%... maybe the 20th century was a bubble in itself, and that 10% figure won't hold up in the 21st.

Traveling ahead 100 years in a time machine and looking back at 200 years of stock market data... where do we stand today on the long term trend. Above the line or below? Hard to tell. I think it is safe to say that 2000 was well above whatever line will be drawn, and I think we all hope 2009 was well below it.

[audreyh1]

Quote:

Originally Posted by MichaelB You may be right. 2.2% real return is not enough to satisfy a 4% withdrawal rate over 30 years. Using FIRECalc, plugging in the 2.2% rate and assuming a low rate of volatility (4% SD) it fails 1/3 of the time.

I thought you only needed a little over 1% real return. I must be remembering things wrong.

[keegs]

On the domestic front there's the inevitable pull back of Fed monetary policy and the volatility it may bring...then there's rising interest rates...

Europe, Japan, China are all facing serious headwinds... certainly is enough worry to go around there.

What are the alternatives to staying the course? Should we be directing future savings to cash equivalents?

[MichaelB]

Quote:

Originally Posted by haha What make this even more challenging is that low returns are usually a product of higher volatility, not lower. IMO it is not a happy prospect. Ha

No disagreement there either. It brings to mind my favorite quote, from Peter Bernstein, who probably forgot more about investing than I will ever know.

Quote:

Equities are still valued at historically high prices. Interest rates, I don't have to tell you, are historically low. And so you start from there, and there you are. I think something very important to think about this, that a period of low returns, you think, well, every year maybe we'll have 4%, 5%. It doesn't work that way. Low returns result from high volatility. You have a big year, and then a bad year, and the pattern of low return periods is high volatility, not low volatility. It's a scary time.

I think the Fed is keenly aware of this and is doing everything it can to keep volatility very low. How long they can keep it down is another matter altogether, and a worthwhile discussion.

[Bikerdude]

Quote:

Originally Posted by MichaelB You may be right. 2.2% real return is not enough to satisfy a 4% withdrawal rate over 30 years. Using FIRECalc, plugging in the 2.2% rate and assuming a low rate of volatility (4% SD) it fails 1/3 of the time.

I put in 2.2% return with 0 inflation and got 95.5 success over 30 years. What am I missing.

[haha]

Quote:

Originally Posted by Bikerdude I put in 2.2% return with 0 inflation and got 95.5 success over 30 years. What am I missing.

Things that go bump in the night.

In fact, if everything proceeds like clockwork, 0 real return and 0 inflation should give you 30 years @ about 3.3% withdrawal. But the volatility will get you when you least expect it.

Ha

[MichaelB]

Quote:

Originally Posted by Bikerdude I put in 2.2% return with 0 inflation and got 95.5 success over 30 years. What am I missing.

My inputs were: portfolio value $1M, spending $40K, and on the "your portfolio" tab, I chose the last option - "A portfolio with random performance" and inputted 5.2% mean return, 3% inflation, and 4% SD. I get a success rate of 69%.

[bondi688]

Sticking to the question asked by OP, the stock market is not cheap now.

[jmzf1958]

I have about $200,000 to invest that I won't need for at least ten to fifteen years. Would you invest it now, and if not, what would you do?

[Bikerdude]

Quote:

Originally Posted by MichaelB My inputs were: portfolio value $1M, spending $40K, and on the "your portfolio" tab, I chose the last option - "A portfolio with random performance" and inputted 5.2% mean return, 3% inflation, and 4% SD. I get a success rate of 69%.

Well, I used the same option and put in 2.2% mean return, 0% inflation and 4% SD and get a different result each time I run it. Some as high as 95% and others lower. I guess that's the random "Monte Carlo" results?

[EvrClrx311]

Quote:

Originally Posted by jmzf1958 I have about $200,000 to invest that I won't need for at least ten to fifteen years. Would you invest it now, and if not, what would you do?

something like VTTVX (Vanguard Target Retirement 2025) it's 70% stocks and 30% bonds at the moment and will transition to safer investments as your 10-15 year mark approaches.