Petey, are you thinking the S&P is in the crapper for 2 years or 20? No crystal ball, I understand. What do people here think of equally weighted index funds?
Hi Laurence,
If you have 25% there, I would suggesting reading Shiller's Irrational Exhuberance. This gives a better breakdown on how valuations & dividend yields affect future expected returns that one can put in a short post. Also John Bogle's Common Sense on Mutual Funds book has some data on the PE ratios thru the decades along with dividend yields and so forth. This is quite instructive even though his main message is index the US and hold thru regardless of price.
Put simply, markets revert to the mean. That is to say, they are a bit like a ball on some elastic. It can stretch out of place only so far and then it tends to bounce back. Sometimes it bounces into the other side (becomes undervalued) but this is what tends to happen. The timing is inexact as markets in the short-term are run not by rational behaviour but by investor psychology which tends to be irrational at best!
The fundemental returns on the market are initial dividend yield + real earnings growth +/- Valuation adjustment. The historical average valuation - the place the market comes back to, overshoots etc., is P/E 14-16. The US stands at between 20-22 now. Historical dividend yield for the US is around 4.5%. Dividends today are 1.8-1.9% for the S&P 500 and not much different for total market. Real earnings growth has been 1.8% for the S&P 500 over past 70 odd years. BTW, Bogle explains this really well, Shiller covers expected returns at different PE valuations really well.
Putting this together you get 1.8% dividend + 1.8% real growth +/- valuation adjustment. The degree of adjustment to the multiple of earnings depends on investor behaviour. Right now on various metrics (see above) the market looks quite overvalued. The odds therefore as that one will see earnings grow but the multiple of those earnings fall. That is a wrinkle that is hard for a lot of people to get their head around - kinda a subtle point! If the market were to come down in the price multiple by 20% over the next 10 years, that would remove some of your total return. This would mean you would receive less than the 3.6% fundamental real return on US total market. No one actually know what will happen when.
In his book Shiller has a chart which shows the returns one received based on different price-to-earnings multiples. The diagram was very clear in that it demonstrated clearly that owning the market much above the long-run average led to lower returns and then negative returns the higher you went. The Bogle argument is that if you have a long enough timeframe then you index thru the entire period and buy some stock cheaply, some at fair value, some expensive but you get average over time. This is not untrue but if one has data which shows those times when you've done badly because you bought/owned at expensive prices, then why not use it? Otherwise it is like being smart but acting dumb! It is also worth noting that the US market has never experienced three decades where PE multiples continued to expand by the decade end. This is now the third decade of expansion, the valuations are high, so the odds are not in our favor of a happy outcome. 15 in the 70s, 7.5 in the 80s, 15.5 in the 90s to 44 in 2000. Now it is 20-22.
People do talk about market timing and that it doesn't work. What this ignores though is that it does make some sense that at a certain price, one should refrain from buying (or holding what you already own). There has to be some sense in that. Jeremy Siegel's recent book also points out that overpaying for stock did not deliver good returns. There are many sources for that observation but Shiller's analysis actually takes a data and shows you how & why this happens.
It is of course possible that investors could bid up the price to earnings multiple some more. Make stocks even more pricey, like they were in the dot com boom. As Shiller points out, you only win there if you can time to sell before the music stops. Problem is, you can't hear the music, you don't know when it'll stop. People think they can do that and fail. So one could hold and hope for added speculative returns from the boomers bidding up stocks - this could happen - but it is unpredictable & history shows holding thru a boom that leads to an equal bust delivers poor returns. So this is an unsound strategy to rely upon.
Beyond Shiller, Jeremy Grantham puts out his monthly analysis of different asset classes and their expected returns based on dividends, real growth, adjustments to profit margins up or down & PE/PB/PFCF multiples vs market averages. He is highly respected. He was one of the few who pulled out of Japan when it was in a bubble. He lost half his institutional clients in the process. Presently he has a low allocation to US stocks principally because he is a US money manager and cannnot pull out completely. He says he would otherwise.
http://www.gmo.com/siteservercontents/marketcommentary/7yrforecasts205.1110218382.pdf
Petey
. Sound to me like you feel a bit better now. Cheers!
