We talk about stock picking on this blog. That means we usually talk about specific stocks. The “market of stocks” not the “stock market”. Today, I’m going to talk about the stock market.
It’s too expensive.
You shouldn’t buy it.
If you have an account where you automatically reinvest your dividends – stop. If you are putting money each month into an index fund, or a stock mutual fund, or a bond mutual fund – stop. Those assets are overpriced. Any basket of stocks or bonds is overpriced. If you are saving money regularly – that newly saved money should now be going into cash instead of stocks or bonds.
The simplest rule in investing is that you never buy an obviously overpriced asset. Stocks generally and bonds generally are obviously overpriced right now. So, you need to stop buying them in a general way.
To put a number on this expensiveness, I think the Shiller P/E ratio is about 27 now. It was about 27 when I wrote my December 2006 post arguing stocks were too expensive. You can read that post later down in this one. Or you can click here to see - via the Wayback Machine - what that post actually looked like on the original site in 2006.
I am writing this post because of 3 separate items I noticed recently.
I came across one while reading an earnings call transcript for Frost (CFR). This is a usually conservatively run bank in Texas. It has a lot more deposits than loans. Deposits have kept growing. So, the company needs to put the money somewhere. And where they’ve put it is “Securities”. Frost now holds more money in securities than loans. These securities are high quality. They aren’t going to default. But they are overpriced. To get a yield near 4% on their securities portfolio – the company had to go pretty far out in terms of the maturities it would buy. In normal economic times – let’s say with a Fed Funds rate of 3% to 4% – these bonds would cost less than what Frost paid for them. At some point, there will be a 3% to 4% Fed Funds rate. I have no idea when that will be. You can look at predictions from the FOMC’s own members and see they thought it would be 3 years down the road or so. Now, if that’s true – you obviously aren’t gaining much by making less than 4% a year for less than 3 years if you will be able to make 4% a year on idle cash at the end of that period. Of course, some events may happen that prevent any increases in the Fed Funds rate for that entire 3 year period. In the 1930s in the U.S. and in the 1990s and 2000s in Japan, investors could have easily overestimated the likelihood that rates would rise within the next 3-5 years to a “normal” level. If something like that happens and you keep all your money at the Fed instead of in long-term municipal bonds and such – you’d have missed out to the point where you now still have $1 when you could have more like $1.12.
You can afford to miss out on those kind of returns. I actually think Frost can too. But, this isn't a post about Frost.
The other two examples don’t involve an actual investor. They are about the “cost of capital”. The car lock maker Strattec uses an Economic Value Added (EVA) approach. They are funding the company with equity right now instead of debt. So, their cost of capital is the cost of their equity capital. They use 10% as the cost of equity capital. Equity investors aren’t going to get 10% a year from this moment forward. Returns will be closer to 5% a year. So, Strattec is really overcharging itself for capital when it presents EVA in the annual report.
And then the last example is a Morningstar analysis I read. The analyst adjusted the value of the company up a little based on lowering the cost of capital for the company – which also uses only equity capital – from 10% a year to 9% a year. This is a concession to the reality that investors are bidding up stocks. But, the cost of equity capital is not 9%. The S&P 500 is not priced to return anywhere near 9% a year. If companies want to issue dilutive stock or borrow long-term – none of that will actually cost them 9% a year.
I understand why Frost, Strattec, and Morningstar don’t spend a lot of time saying today’s stock and bond prices are much higher than stock and bond prices have been through most of history. But not harping on that can make people forget how abnormal today's stock and bond prices are.
I think there is a big danger of complacency here. Investors seem to be pretending today’s prices are comparable enough to past prices that it’s not worth focusing on. At many points in the past, you could make close to 10% a year in stocks. Today, you can’t. And at many points in the past, it was safe to buy bonds at the market price and not expect a very large drop in their market price. Today, it’s not.
Both the likelihood of 10% returns in stocks and the unlikelihood of large paper losses in bonds was due to their prices. They were lower. As a group, stocks and bonds are the same assets they always were. Increases in the price of those groups simultaneously lowers long-term future returns and increases the risk of short-term negative returns.
A little bit later in this post I’m going to give you the entirety of something I wrote back on December 29th, 2006. That was about 8 and a half years ago. If you had stayed completely in the Dow from that moment till now rather than staying completely in cash from that moment till now the difference would be like 5% a year. Of course, you shouldn't have stayed in cash for 8 years. You should have stayed in cash till prices were "normal" again in late 2008-2010. Listening to Shiller or Grantham or this blog or any value investor would've told you prices were okay again once the crash happened.
I thought stocks were too expensive in December of 2006. The Fed Funds rate went to 0% and stayed there. Stocks are – by the Shiller P/E and other such normalized measures – a lot more expensive than they’ve ever been except for years like 2007, 1999, and 1929. So, all of those factors have helped stock returns from the end of 2006 to midway through 2015. And yet returns were no better than the about 5% or 6% a year I warned was likely back in 2006. They were not the often hoped for 9% or 10% a year that people cite as the “cost of equity” and the return investors in stocks expect long-term.
When you might earn 10% a year in the stock market – the cost of not participating is high. When the best you can hope for is 5% or 6% a year – as the period from high stock prices in 2006 back up to high stock prices again in 2015 shows – you aren’t missing much by sitting out till you get an acceptable price.
I am not saying you shouldn’t pick stocks. If you find a business you like at a price of less than 10 times normal EBIT – you can buy that business. That’s a good price in all environments.
So, you can pick absolute bargain stocks. That means a business you like at less than 10 times EBIT. The danger is settling for relative bargains. If the market trades for 15 or 20 times normal pre-tax earnings - then I can pay 13 times for this business and it's a steal. That's dangerous thinking. What you're really saying is that you can never hold cash. The best you can do is to buy something a bit cheaper than the very high price everything else happens to be priced at right now.
Obviously, you should stop contributing more cash to stock funds, bond funds, etc. Stop reinvesting your dividends. Build up cash till you find a bargain for all times – not just for these very expensive times.
I’m not going to spend the rest of this post arguing about today’s stock market level. It’s clearly too high. And future returns will be much worse than past returns. But, I’ve found it is hardest to argue about the present. It is easier to use an illustration from the past which can serve as an analog for today.
So, I am re-posting my December 29th, 2006 piece “In Defense of Extraordinary Claims”. In that post, I argued that:
“Normalized P/E ratios can fall in several ways. However, there are only two ways that seem reasonable given current conditions. Stock prices can either fall over the short-term or they can grow slowly (at less than 5-6% a year) over the long-term.”
“Stocks are not inherently attractive; they have often been attractive, because they have often been cheap. The great returns of the 20th century occurred under special circumstances – namely, low normalized P/E ratios. Today's normalized P/E ratios are much, much higher. In other words, the special circumstances that allowed for great returns in equities during the 20th century no longer exist.
So, don't use historical returns as a frame of reference when thinking about future returns – and do lower your expectations!”
Just about 8 and a half years later, I want to reiterate those same two points. They are as true now as they were at the end of 2006. We are in the same place. Stocks are too expensive again. They can either drop a lot in the short-term. Or they can rise at less than 5% or 6% a year for the long-term. So, when you ask “Should I hold cash?” instead of adding to my mutual funds, reinvesting my dividends, etc. you should think of 3 possible outcomes: 1) I buy stocks and the market crashes in the short-term 2) I buy stocks and they return less than 5% to 6% for the long-term 3) I hold cash instead of buying stocks.
Because those are the only 3 reasonable outcomes. I’m not suggesting you time the market by selling stocks you already own. Nor am I suggesting you stop buying stocks that are good purchases in any market. I don’t think knowing that stocks are too expensive means you have to sell what you already own. Nor do I think it means you have to give up on buying businesses you like at less than 10 times EBIT. That’s always a good decision.
But, knowing stocks are too expensive right now should lead to you cutting off all additional contributions to your mutual funds and index funds till prices return to their normal historical range.
What is that range?
That’s the question I tried to answer in my 2006 post. Here is that post – completely unedited – and just as relevant in 2015 as it was in 2006.
I have one added note. In what you're about to read you'll see I used my own measure of the "normalized P/E ratio" for the Dow rather than the Shiller P/E for the S&P 500. It doesn't matter which you use. I'd just go with the Shiller P/E myself - and I'm the one who made up the measure you're about to see. Both normalized P/E ratios will usually tell you about the same thing at about the same time.
Shiller uses an inflation adjusted 10-year average. I use a 15-year average with a 6% nominal annual escalator in EPS.
For those who care about this stuff: My method was to apply a 6% growth rate to each of the last 15 years of earnings. So, to predict "normal" earnings in 2015 you simply project actual EPS for every individual year from 2000 through 2014 forward at a rate of 6% a year. You assume the average of all these "past projections" is more normal than what is actually reported as for 2015.
(“In Defense of Extraordinary Claims” – Originally Posted: December 29th, 2006)
About two weeks ago in a post entitled "We Have Some Bearish Bloggers Out There", Bill Rempel wrote, "Personally, I’m in the 'extraordinary claims require extraordinary proof' camp." I'd like to think I am too, because Bill is right – extraordinary claims do require extraordinary proof.
So, before making any extraordinary claims about future long-term market returns (i.e., predicting future returns that differ substantially from historical returns), I'd like to spend this post laying out the case for why current circumstances are extraordinary. After all, extraordinary times call for extraordinary claims.
Essentially, this is a post about why the present is unlike the past and what that means for the future.
In a previous post, I wrote:
Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.
Unless they internalize this fact, investors risk assuming that historical returns that existed under special circumstances can continue to serve as a useful frame of reference, even when these special circumstances no longer exist.
Later in this post, I will discuss the possibility of a "paradigm shift" (i.e., a change in basic assumptions within the theory of investment) that began in 1995. The only other period in the 20th century which saw similar upheaval in investment thinking was the 1920s.
Common Stocks as Long Term Investments
That theoretical crisis (and the higher valuations that followed it) has often been partly attributed to a thin volume published in 1924 by Edgar Lawrence Smith. The book was called "Common Stocks as Long Term Investments" and it was based on a study of 56 years of market data (1866 – 1922).
Smith found that stocks had consistently outperformed bonds over the long run. Neither the data in support of this conclusion nor the logical explanation for this outperformance (public companies retain earnings and these retained earnings lead to compound growth) was wrong.
However, a few years after Smith's book was published, the special circumstances of the past disappeared as stocks (which had historically had higher yields than bonds) saw their prices surge and their yields plunge. Soon, stocks had lower yields than bonds – part of the reason for their past outperformance (the initial yield advantage) was gone and the margin of safety which a diversified group of stocks had offered over bonds narrowed considerably.
Simply put, circumstances changed. John Maynard Keynes saw this possibility when he reviewed Smith's book in 1925:
"It is dangerous…to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was."
That has been the objective of this little study from the outset. In this post, I will focus on how the circumstances of the present differ from the circumstances of the past.
I will also endeavor to demonstrate that historical returns were the result of special circumstances, which (logically) need not apply now or in the future. The historical data suggests these circumstances may yet return – and for the sake of net buyers of stocks, I hope the data is right and one day (soon) historical returns can once again serve as a useful frame of reference for the future.
Today, however, historical returns have about as much utility to the investor as the success rate of a procedure performed exclusively on 25 year-old men has for the surgeon who is preparing to operate on a 92 year-old woman.
There is nothing wrong with the data itself. But, there is something wrong with the assumption that data collected from one special case has predictive power when applied to another special case.
Cheap Stocks and Great Returns
Historical returns in equities have been great. However, it's worth noting that throughout the period we're referring to, stocks have often been cheap. How cheap?
Once again, here's a graph of the Dow's 15-year normalized P/E ratio for each year from 1935-2006:
From 1935-2006, the Dow's normalized P/E ratio ranged from 6.88 – 30.84. The Dow's average (mean) normalized P/E ratio for these years was 14.18. The median was 13.91.
Those figures include the 1995-2006 period, which I will discuss in greater detail later. For now, let's start by taking a look at the period from 1935-1994.
Until 1995, the Dow's normalized P/E ratio had ranged from 6.88 – 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41. In other words, the Dow's average 15-year normalized earnings yield was just over 8%.
I would estimate that in a little under 45% of all years, the Dow was priced such that long-term investors were effectively paying little or nothing for future earnings growth. Most market authorities would disagree with me on this point, because they would require an equity-risk premium.
Equity-Risk Premium – An Aside
This isn't the place to have a long argument about the concept of an equity-risk premium. For now, I will simply say that you can not arrive at the conclusion that there is an equity-risk premium via deductive (a priori) reasoning. If you were locked in a room alone, you would never come up with the idea of an equity-risk premium. It is only in seeing the effect that you would seek out a cause.
You can only come to the conclusion that an equity-risk premium should exist by first knowing that it has existed. You have to work backwards from the effect to the cause. That's troubling, because history consists of a series of special circumstances. It is non-repeatable.
So, the existence of a measurable aversion to stocks over some historical period does not necessarily lead to the conclusion that such an aversion is the result of a general principle (i.e., an inherent equity-risk premium). In fact, such a conclusion could merely be a contrived attempt to explain away an observable effect that has existed under certain circumstances – but needn't always exist.
The equity-risk premium isn't a general theory. It's really little more than the acknowledgement that during the historical period being studied, market participants made choices that reflect an aversion to stocks compared to the choices an optimal return seeking automaton would have made.
It's an interesting observation – but, it's not a theory.
How Common Are Cheap Markets?
Returning to the question of how often the stock market has been cheap, I would estimate that during the period from 1935-2006, the Dow was priced to offer double-digit returns somewhere between 75% and 85% of the time.
Here, I don't mean that the Dow did provide double-digit returns 75% to 85% of the time; nor, do I mean that past performance suggested it should provide such returns. Rather, I simply mean that valuing the Dow as an asset to be held until Judgment Day, would lead a clear-headed observer to conclude that double-digit returns were likely in about 75% to 85% of the years being considered.
I know this 75% to 85% number is a bit hard to swallow. So, if you don't believe me, consider what Warren Buffett wrote on the same topic in his 2002 annual letter to shareholders:
"Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge."
"The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns…we will sit on the sidelines."
Buffett's "50 or so years" of his 61 would translate into just under 82% of the time. He wrote that letter in early 2003. The four years since haven't offered the kind of opportunity he looks for, while the seven years included in the study from before Buffett started investing did offer that kind of opportunity.
So, according to my math, that would work out to be a roughly 80% estimate from Buffett over the full 1935-2006 period. That estimate falls within the 75% - 85% range I cited based on the data.
I think this 75%-85% range is the best estimate you'll find for how often the market has been so cheap as to offer double-digit returns when valued as an asset with a holding period of forever.
Unfortunately, I'm afraid a lot of investors don't realize (or haven't internalized) just how often the stock market has been really cheap. During the 1935-2006 period, stocks were priced as clear bargains in about 8 out of every 10 years. Buffett supports this conclusion with his assertion that stocks could be "purchased at attractive prices" about 80% of the time (50 out of 61 years).
If investors don't start with an understanding of the fact that stocks have been so cheap so often, they won't be able to put the historical data in its proper context. If you have a population that consists of 80% x and 20% y, is it reasonable to assume that data based on the entire population is a good reference point for your subject, if you know your subject is a y rather than an x?
In terms of valuation, 2006 (and thus 2007) is undoubtedly a minority year. Unfortunately, data based on a full population sometimes has little or no relevance when applied to a member of a minority group.
For instance, Turkey's population is 80% Turkish and 20% Kurdish. My guess is that data based solely on the full population of the country (which would consist of 80% ethnic Turks) would tell you very little about any particular Kurd. Now, if you broke the data you had collected down into a Turkish group and a Kurdish group and used the Kurdish group to predict something about an individual Kurd – then, you might be on to something.
A More Detailed Look
From 1935-2006, the Dow's normalized P/E ratio ranged from 6.88 to 30.84. The Dow's average (mean) normalized P/E ratio for these years was 14.18. The median was 13.91. In half of all years, the Dow's normalized P/E ratio fell between 10.53 and 16.43.
Here's a breakdown of how common various normalized P/E ratios were from 1935-2006.
Normalized P/E of 5-10: 18 of 72 years or 25.00% of the time
Normalized P/E of 10-15: 28 of 72 years or 38.89% of the time
Normalized P/E of 15-20: 17 of 72 years or 23.61% of the time
Normalized P/E of 20-25: 5 of 72 years or 6.94% of the time
Normalized P/E of 25-30: 3 of 72 years or 4.17% of the time
Normalized P/E of 30-35: 1 of 72 years or 1.39% of the time
Fifteen Years Later…
For the years with a normalized P/E ratio between 5 and 10, compound point growth in the Dow over the subsequent fifteen years ranged from 4.01% to 15.69%. The average (mean) growth rate was 10.17%. The median growth rate was 10.03%.
For the years with a normalized P/E ratio between 10 and 15, compound point growth in the Dow over the subsequent fifteen years ranged from 0.92% to 12.28%. The average (mean) growth rate was 7.01%. The median growth rate was 8.17%.
For the years with a normalized P/E ratio between 15 and 20, compound point growth in the Dow over the subsequent fifteen years ranged from (0.14%) to 8.93%. The average (mean) growth rate was 2.19%. The median growth rate was 1.76%.
I'd love to show you the same data for the three highest normalized P/E groups. But, I can't.
There is no fifteen year point growth data for years with a normalized P/E over 20, because the Dow didn't record a year with a normalized P/E ratio above 20 until 1996. In fact, until 1995, the highest normalized P/E ratio on record was 17.40 – that high-water mark was reached in 1965. With the benefit of hindsight we now know 1965 was not an ideal year to buy stocks for the long-run.
Today's normalized P/E ratio is extremely high. So what? Hasn't the normalized P/E ratio been rising over time, as investors have come to realize a diversified group of stocks held for the long-run is actually a low-risk, high-reward bet?
I'll let you judge for yourself. I won't even connect the dots for fear of biasing you.
Here's a chart showing the Dow's 15-year normalized P/E ratio for each year from 1935-1994:
Do you see a trend towards higher normalized P/E ratios over time?
I cut the graph off at 1995 for a reason. That's the year everything changed. You'll remember I said the Dow's highest normalized P/E ratio had been 17.40 reached in 1965.
Although I didn't include the data necessary to compute 15-year normalized P/E ratios for years before 1935, I do have enough data to know that the three "peak" normalized P/E ratio years during the 20th century were 1929, 1965, and 1999.
By "peak" years, I simply mean the three highest years that aren't part of a chain of continuously higher normalized P/E years – unless they're the highest year in that chain. Without this qualifier, the highest normalized P/E list would be monopolized by the years from 1995 – 2006. Each year in that group had a higher normalized P/E ratio than every year prior to 1995.
In other words, since 1995, the Dow's normalized P/E ratio hasn't just been above the mean, it's been above the entire normalized P/E ratio range from 1935-1994. You can see that clearly in this graph, which shows the Dow's normalized P/E ratio for each year from 1935 – 2006:
This graph is essentially just a continuation of the earlier graph. In fact, if you cover the points from 1995 – 2006, you can see the familiar outline of that graph with its long undulations and its frothy crest at 17.40. That bound was reached in 1965. In 1995, the Dow broke out of this upper bound and hasn't returned since.
In this graph, it certainly does look like there's a trend toward higher normalized P/E ratios. However, that trend only emerged over the last decade – not the last century.
In other words, the Dow's normalized P/E ratio hasn't been rising over time. It simply surged in the 1990s. That surge may be justified. However, it's certainly a departure from the historical data. As a result, there's no reason to believe historical returns from 1935-1994 have any utility whatsoever in predicting market returns in the new era that has emerged since 1995.
All the historical return data from before 1995 was based on lower normalized P/E ratios. Once again, I don't mean the pre-1995 period had lower average normalized P/E ratios – I mean that no year from before 1995 had a normalized P/E ratio equal to or greater than any year from 1995 through today. Simply put, since 1995, market valuations have been in completely uncharted territory.
The only years with normalized valuations comparable to today's occurred during the 1995-2006 period. So, referring to historical return data requires a choice between using data from recent years or using data from dissimilar years.
Is it possible that the surge in normalized P/E ratios beginning in 1995 was simply the culmination of a crisis within the investment discipline? Maybe normalized P/E ratios have reached "a permanently high plateau" now that a new paradigm has taken hold.
I won't dismiss this argument entirely. There is some logic to it. After all, stocks have been an unbelievable bargain for most of the 20th century. Why should that continue to be the case? Eventually, won't enough investors wise up to this fact and cause the so-called "equity-risk premium" to disappear.
If the normalized P/E ratio remains extremely high, there will be no need for stock prices to fall. Of course, these higher valuations must necessarily cause future returns to fall short of historical returns. But, there's no logical reason why normalized P/E ratios must revert to the mean – future returns can be adjusted down, allowing current prices to remain high.
That's true. In fact, the Dow could theoretically trade around a normalized P/E ratio as high as 40-50 without making stocks so unattractive as to completely eliminate them as a possible long-term investment (all of this assumes the equity-risk premium can disappear).
At around 50 times normalized earnings, the math gets terribly unforgiving. As a result, it's hard to imagine any likely circumstances under which a market trading at close to 50 times normalized earnings could be a viable investment option – though it's theoretically possible if long-term interest rates are very, very close to zero.
But, at lower normalized P/E ratios, such as 30 (and certainly 20) stocks could still compete with other investment opportunities. Stocks might lose most (or all) of their edge over other asset classes; but, stock prices wouldn't necessarily have to fall – they could simply offer much lower returns than they had in the past. This could continue indefinitely – in theory.
I say "in theory", because that seems a rather unlikely scenario. There is absolutely no evidence for it in the data.
Before 1995, the Dow's normalized P/E ratio had ranged from 6.88 – 17.40. The average (mean) normalized P/E ratio from 1935-1994 was 12.31. The median normalized P/E ratio was 12.41.
So, a permanent jump to normalized P/E ratios above 20 would be quite a departure from the past. Could the leap be permanent? Could these new, higher normalized P/E ratios become the new norm?
Maybe. If we really are in a new era, the old historical return data isn't relevant – it applies only to an era of low normalized P/E ratios. New, higher valuations must necessarily lead to new, lower returns. On the other hand, if we aren't in a new era, the old historical return data is relevant – and normalized P/E ratios must fall.
Adjusting to the Norm
Normalized P/E ratios can fall in several ways. However, there are only two ways that seem reasonable given current conditions. Stock prices can either fall over the short-term or they can grow slowly (at less than 5-6% a year) over the long-term.
The data from 1935-2006 doesn't provide much support to one route over the other. In the past, extraordinarily high normalized P/E ratios have been brought down to more normal levels through crashes and through stagnant markets.
The market can reach a more "normal" normalized P/E ratio by going down fast or going sideways for a very long time. During the 20th century, we saw normalized P/E ratios fall both ways.
To return to the 1935-1994 normalized P/E range, the Dow would need to trade around 10,135. That would simply bring it down to a valuation comparable to 1965.
To return to the average normalized P/E ratio for 1935-2006, the Dow would need to trade around 8,260. If the Dow were to trade at the average normalized P/E ratio for the 1935-1994 period, it would need to trade around 7,230.
Are any of these numbers likely destinations? The truth is stocks have probably been too cheap in the past and they're probably too expensive today. Regardless, the Dow has been above 1965's old normalized P/E high since 1995. So, for a little over a decade now, the market has been in uncharted territory. A normalized P/E ratio of 20-25 (today's is about 21.50) is quite compatible with decent long-term returns for stocks relative to other asset classes.
However, such high normalized P/E ratios are not compatible with the kind of long-term returns seen during much of the 20th century.
Stocks are not inherently attractive; they have often been attractive, because they have often been cheap. The great returns of the 20th century occurred under special circumstances – namely, low normalized P/E ratios. Today's normalized P/E ratios are much, much higher. In other words, the special circumstances that allowed for great returns in equities during the 20th century no longer exist.
So, don't use historical returns as a frame of reference when thinking about future returns – and do lower your expectations!
(End of December 29th, 2006 repost)