Wednesday, November 24, 2010

Say what you want about the current level of stock prices, but at 22 times earnings, stocks are anything but cheap.

Never underestimate Wall Street’s ability to shake the money tree. The newest pitch can be seen in this recent note sent out by a local brokerage to clients and prospects:

“…there have only been three 20-year trailing periods since 1926 where bonds have outperformed stocks: 1912-1932; 1930-1950 & 1989-2009. In each 10-year period following these 20-year periods of underperformance, the average increase in the U.S. stock market was 19.8%% per year!!

Source: The Leuthold Group/Calamos Advisors

Secondly, whenever the stock market returned less than 5%/yr. for any 10 year period, the next 10 year average annual return was 13%...with a range of 7% to 18%...without exception!!

Source: Davis Funds”


Now a note such as this one is obviously intended for only one thing — to stir up the speculative juices and get people to open their wallets. Who doesn’t want to make easy money?

At first glance, the above easy money scenario might sound plausible, but if you look a bit more closely, there’s an inconvenient truth that’s a little hard to brush past.

It’s critical to note what the starting points of the first two periods referenced in the e-mail have in common that is not shared by the market today. In a word, both in 1932 and 1950, the market, based on valuation, was cheap. Very cheap. Today, not so much.

Earlier this summer, I wrote a column titled “Revaluing Wall Street.” It addressed the long-term market cycles that revolved around market valuation. Included in the column was a long-term market chart of the valuation cycle for stocks.

The valuation chart clearly shows that stocks have always cycled from periods of low valuation (P/E10 in single digits, 1921, 1932, 1950, 1982) to periods of overvaluation (P/E10 greater than 20, 1902, 1929, 1937, 1965, 2000).

Yes, the subsequent 10-year returns following both 1932 and 1950 were impressive. But in both of those following 10-year periods, stocks started from extraordinarily cheap valuations (5.6 and 9.1 times earnings, respectfully). For both of those starting points, the first half of buy-low-sell-high was right on target.

So, what about today? Are stocks cheap? Hardly. Would you believe that today — after 10 years of turbulence — the valuation level of the market stands at, drum roll please, 22 times earnings?

Now while valuation is a poor short-term timing tool, it is an excellent tool to estimate long-term expected returns. As with any investment, your return in the market is a function of your cost. Start from the bottom step, buy cheap, and you’ve got the wind to your back. Start from the top step, buy high, good luck. Say what you want about the current level of stock prices, but know this: At 22 times earnings, stocks are anything but cheap.

Note for math geeks: The valuation chart below can be divided into horizontal bands dividing the monthly valuations into quintiles — five groups, each with 20 percent of the total. Ratios in the top 20 percent suggest a highly overvalued market, the bottom 20 percent a highly undervalued market.

While the market decline that occurred in 2008 drove valuation down substantially, the price rebound since the 2009 low has pushed that valuation right back to the top of the historical range.

And here’s the rub: Dating back to 1870, every time the P/E10 has fallen from the first to the fourth quintile (as has in fact happened from March 2000 through March 2009), it has ultimately gone on to finally decline to the fifth quintile, bottoming out in single digits.

Investing is serious business. Expectations of stellar 10-year returns ahead, based primarily on the poor performance of the last decade, is to simplistically regard your investment portfolio that you are counting on. But as always, there is nothing new under the sun. The greed and hope card — played so many times by Wall Street to pull in new money — works (recall the investment hype of the mania of the late ’90s). P.T. Barnum would agree.

An ultimate bear market bottom in the single digits (should that occur), starting from today’s valuation level of roughly 20, implies that the potential for a difficult market at some point in the future remains. To ignore that possibility would be foolish. Investors would do well to review both their asset allocation and risk control now, while the markets are enjoying a period of relative calm. If this current secular bear market follows the script of history, you (and your wallet) will be glad that you did.

Bo Billeaud has been president and chief investment officer of a Lafayette-based money management firm for the past two decades. Contact him at This email address is being protected from spambots. You need JavaScript enabled to view it. . To comment on this story, e-mail This email address is being protected from spambots. You need JavaScript enabled to view it. .

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