Thursday, May 29, 2014

The big picture is not very scary

The U.S. stock market has been rising for more than five years; the S&P 500 has delivered a total return of 217% since early March, 2009. Today the S&P 500 reached a new all-time high of 1920. You can hear the nail-biting, especially since Q1/14 real GDP notched negative with today's revision. Are we near the end of one of history's great stock market rallies? I don't think so.

These two charts help put things in perspective. The big picture is that the natural tendency of stock prices is to rise, which they have been doing for a very long time; that should hold as long as the economy is able to expand and inflation avoids negative territory. Economic growth is almost assured given ongoing growth in the population and in the number of jobs, and the Fed has taken extraordinary measures against an extended outbreak of deflation. As the top chart shows, stocks tend to rise, on average, about 6-7% per year in nominal terms (plus dividends). As the second chart shows, stock prices tend to rise about 3% per year in real terms (plus dividends). Prices are in the upper half of their long-term trends, but it's not what you might call "scary-overvalued." There is still plenty of room on the upside before historical precedents are violated.

This is also a plug for "buy and hold" investing. It's near-impossible to call the highs and lows with enough exactitude to make a fortune. But's it's easy to buy stocks when no one wants them—as was the case from late 2008 to early 2009—and hold on for the long haul.

The message of the first two charts—that stocks are a little above their long-term average growth path—is confirmed by the chart above. The 12-mo. trailing PE ratio (according to Bloomberg) of the S&P 500 is now 17.6, which is about 6% above its 55-year average of 16.6. By this measure, stocks are somewhat "overvalued," but not be a significant amount. Moreover, if you consider that Treasury yields are still historically low (the PE ratio of the 10-yr Treasury, which currently yields 2.5%, is 40), it's not unreasonable at all for PE multiples on equities to be above average. Show me an investor who prefers 10-yr Treasuries to equities today, and I'll show you an investor who expects corporate profits to plunge. Absent a plunge in profits, equities could handily outperform Treasuries, even on a risk-adjusted basis.

4 comments: said...

Looking at the first two charts, I can see why some people think the market looks scary. It looks like we are at the 1987 point, but I don't remember what the yield curve looked at in 1987.

Right now, we have a strong positively sloping yield curve (low short rates, higher long rates). IMO, until we sustain a negative yield curve for a certain period of time, I see earnings growth and the S&P heading higher.

NormanB said...

The 30yr Treasury is yielding 3.3% and over the next 30 years that $33 you'd get in 2044 with a 2% inflation rate will be worth $18 in 2044 buying power. Further, that $1,000 you bought the bond for would have a maturity buying power of $552.

Compare this to JNJ now yielding 2.8% (50bp less than the T-Bond) but at least for the last 5 years the dividend has grown by 7.4% per year. Considering the the world will need JNJ products forever in 30 years it should be a good play. At the thirty year mark the JNJ dividend after inflation would give you a buying power on a like $1000 investment of $885 which is 49X what you'd be getting from the T-Bond. Further your JNJ stock in real value should be worth $4844.

So putting aside all matters of what is around the corner what should you give your newborn child? The T-Bond or JNJ. As the on TV salesman says, This is a No Brainer.

steve said...

dividends are completely overrated as they are a discretionary decision by the board. BRK has never paid a dividend. bad stock? rather, look at earnings growth over time, which is directly correlated to stock price. as larry kudlow love to say, "earnings (profit) are mothers milk of socks price. the truth is timing stocks is a fools game and EXPENSIVE. you can buy VFINX and pay vanguatd .17% mgmt fee. if you believe as I do that earnings will not be as strong over next 10 yrs or so and therefore stock appreciation may not be as high, KEEP YOUR EXPENSE OF STOCK OWNERSHIP DOWN!

steve said...

and speaking of stocks, I've been in the business for over 30 yrs and cannot remember a market that has been so quiescent.