Monday Morning Jumpstart with Dan Richards
10 minutes to drive your week
Topic for July 18, 2010: Making the case for stocks
- Today, many investors are paralyzed and have money earning next to nothing in cash. That's fine if someone only needs a 1% or 2% return to hit their long term goals – but for many investors the current allocations mean it will be impossible to achieve their long term goals.
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Early March featured the one year anniversary of last year's stock market lows and the ten year anniversary of the tech bubble high of early 2000.
In honour of those anniversaries, the Wall Street Journal ran a feature story with the leading proponents of the undervalued and overvalued cases – Wharton's Jeremy Siegel, author of Stocks for the Long Run and Yale's Robert Shiller, who wrote Irrational Exuberance.
Notably, both went on record in early 2000 to the effect that tech stocks were overvalued and at unsustainable levels – but since then have diverged on their assessments of stock market valuations. Ten days ago, I travelled to Philadelphia and New Haven and spent an hour with each of Professors Siegel and Shiller.
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Shiller begins by looking at corporate earnings adjusted for inflation over the past ten years – looking back ten years eliminates short term distortions in any given year.
Over the past hundred and fifty year, stocks have traded at an average multiple of sixteen times an average of the past ten year earnings. When beneath this level, they're cheap and have tended to do well in the following period; when above this level, they're expensive and have underperformed in the years that follow.
Today, stocks trade at around twenty times their year earnings. While not close to the peak level of forty times historical earnings they hit in 2000, this is still historically expensive – and suggests returns in the period ahead bel the long term average of 9% before inflation and 6% after inflation.
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Siegel uses a different method to value stocks and reaches a different conclusion – his analysis suggests that compared to long term averages stocks are undervalued by 30% or more.
The biggest difference between his approach and Professor Shiller's is that his is forward looking, focusing on consensus earnings forecasts for this year and next. Among his criticisms of Robert Shiller's methodology is that mega-writeoffs such as the $80 billion writedown by AIG will distort the earnings base from which backward looking calculations are conducted for years to come.
Siegel has looked at U.S. stock market valuations over a 200 year period. During that time, the average stock multiple of earnings has been 15 times – that compares with a multiple of consensus earnings forecasts of 13 times for this year and 11 times for n.
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Siegel's average of 15 times earnings includes periods of double digit inflation, when multiples are typically depressed – excluding periods of double digit inflations, the average multiple that the market paid for earnings was 17 times.
If earnings forecasts for next year are accurate, then returning to that long term average of 15 times earnings would see stocks increase by 35%, rising to the historical low inflation valuation norm would see stocks rise by 50%.
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Jeremy Siegel has plotted a long term rising trend line in profit levels and stock market prices, going back 200 years. When stock prices get above that trend line as they did in 2000, typically underperformance follows – and often prices drop below the trend line.
Jeremy Siegel points out that when stock market prices are below the trend line, as they are today the lesson of history is that a period of outperformance follows – although he does caution that just as stocks can stay above the historical valuations norms for long periods of time, so they can stay below them, and investors do have to be prepared to be patient.