While the media was chasing the Anthony Weiner story this summer, the rest of us were about to get caught with our own investing pants down.
Between weak GDP growth, fears of Italian politicians swilling and partying their way into oblivion, and a standoff in Washington, people panicked and vaporized $8 trillion dollars out of stock markets around the world in just two and a half weeks. Nothing ado about that now, but what should we do next?
A few days ago, Henry Blodget suggested that stocks are still overvalued by ~30%. He was wrong in his reasons, but I agree with his conclusion. For any of my friends considering investing, here’s a dollar’s-worth of my two cents:
Why stocks move
Firstly, stock prices live and die by their three factors: earnings, investor exuberance, and inflation. Let’s take a quick look at each one(1):
Shiller’s P/E index
Shiller’s price to earnings (P/E) ratio, which Henry looked at, measures investor exuberance (or recklessness). Blodget compares the current(2) adjusted P/E ratio of x21 to the historical average of x16 since 1880.
Specifically, even after the crash, stocks are still trading at 21X cyclically adjusted earnings, as we can see in the following chart from Professor Robert Shiller of Yale. Over the past century, stocks have averaged about 16X those earnings. So we’re still about 30% above “normal.”
But, adjusted P/E ratio rarely stays around the average. A much better way to look at it is by quartile.
At x21, we’re just at about 76th percentile. In other words, there is certainly room for P/Es to drop, but we’re in a pretty normal range, where we could easily stay for a few years.
Somewhat important to whether we will or won’t is interest rates. Shiller is very careful in his critique of a direct, causal correlation between interest rates and stock and real estate prices.(3) However, the period of the Great Depression notwithstanding, interest rate is certainly a key factor in the decision as to whether to park one’s money in traditional, predictable bonds or to try out stocks or even sexier (though by no means better) investments like hedge funds, private equity, or venture capital.
Ridiculously low interest rates are clearly not enough to prop the market up on their own. We’ve seen this loud and clear in the last few weeks and after stock market crashes like 1929 and 2000. But still, low interest rates are a positive factor for stocks.(4)
The second component for stock prices is inflation. Though inflation is as powerful a force in economics as gravity is in physics, it almost doesn’t matter for the next few years. In the U.S., we’ve now almost forgotten what inflation—prices for the same very thing increasing year after year—really feels like. While gas prices are pinching at the pump, we almost expect everything else to act like iPods—with dramatic price drops every year.
The last unknown lies in earnings. I personally think that’s where the worst outlook hides. American business leaders, more-so than Congress, provided the piss-poor leadership in this economic crisis.
First, Wall Street was a cheerleader to reckless lending. Since, it has cheered corporate managers who, unlike Apple, have stopped innovating and taking risks and who’ve mortgaged their companies’ long-term growth for short-term profits. But, there is, in fact, no free lunch and firing people rarely leads to innovation. With top lines not growing and no more room to squeeze the bottom, we’re in for a destructive tug of war in every boardroom: Should our firm bet on hiring more people (lowering the unemployment rate and creating a virtuous cycle) or bet on keeping things the same (creating flat to negative conditions)?
Add to this a shrinking public sector, and we’re facing quite a headwind.
To sum up, things are OK on price-to-earnings, somewhat positive on interest rates, neutral on inflation, and (I believe) negative on future profits.
Which takes us back to P/E ratios and possible stock market returns over the long term. Prof. Shiller graphed the data based on the P/E on Jan. 1 of each year.(5)
At 21x, we’re in pretty healthy territory. Unlike at 24x, which has led to a good 10-year outcome only once, in most years if you were where you are today you’d be well-off into future. Not as well-off as if we had a 16x P/E, but still.
The only thing: I don’t expect this time to be one of the good ones.
So, common-sense investment rules apply now more than ever. This isn’t 2008 after the crash, when we truly, deeply oversold boosting returns for the next two years: if you want your savings to grow now, don’t expect the stock market to lift you up, it won’t. The Fed is not raising interest rates, so don’t expect bonds to help you much either (though neither should they hurt).
- - Value your cash. Short-term: stocks may go up or down, but I’d rather take cash (and cash-like things) than those odds. Mid-term: until housing picks up again, we’re in for a few years of stagnation. Long-term: we’ve worked through worse before (World War II anyone?), it all will be OK.
- - Be opportunistic. Seek out entrepreneurs, big and small, domestic and abroad, who are taking risks and reinventing their businesses.
- - Don’t overpay for growth. Don’t put money that you can’t stand to lose into bubbles.
Good luck! If Tiger Woods can make a comeback, so can we.
1) Importantly, we can’t look at jobs to tell us much about the stock market. Stocks often fall ahead of recessions and rise long before those are over, while jobs tend to trail recessions.
2) As of 08/04/11. The market lost 6.4% since then, as of this writing.
3) Irrational Exuberance (2005):
On stocks: “In the late 1990s and the early 2000s, it became fashionable to use the [relation between the stock market and the 10-year interest rate] to justify the level of the market. Indeed, with declining interest rates one might well think that stock prices should be rising relative to earnings, since the prospective long-term return on a competing asset—bonds—was declining, making stocks look more attractive in comparison…. However, the evidence… is rather weak…. Although interest rates must have some effect on the market, the behavior of the stock market is not just a predictable reaction to interest rates.”
4) One of the reasons why interest rates can matter is that, historically, stock markets tend to be depressed during periods of high inflation and high nominal interest rates (even when real interest rates are low) due to a “money illusion”. (Irrational Exhuberance, citing on Modighliani & Cohn)
5) We’ll use it as a proxy for today’s P/E ratio.