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How Expensive Are Stocks ? (Not Terribly)

FYI:
It has become commonly accepted that stocks are very expensive, overbought and perhaps even in a bubble [2].
JPMorgan Chase & Co.’s latest quarterly chart book (you can download it here [3]) takes issue with those conventions.
Regards,
Ted
http://www.ritholtz.com/blog/2014/07/how-expensive-are-stocks-not-terribly/print/

Comments

  • Don't they always take issue? Don't they always tell us things going forward are swell?
    Didn't some big names predict continued growth right before the great recession crash?
  • This is extremely interesting to me since Shiller CAPE has become such a meme:

    >> If you avoided equities while they were above their historical CAPE measurement, you just missed 24 years of equity gains.
  • The S&P 500 forward 12 month P/E they are using from JPMorgan is 15.6
    That seems too low based on Morningstar and the WSJ
    The WSJ shows a forward P/E of 16.74
    Morningstar shows a forward P/E of 17.01 for the S&P 500 in their portfolio data for VFINX, and 17.42 in their portfolio data for SPY and IVV

    At any rate, the difference between the JPMorgan forward 12 month S&P 500 P/E of 15.6 and Morningstar's 17.01 or 17.42 seems significant.

    Their conclusions might have been different had they used a higher P/E

  • This is extremely interesting to me since Shiller CAPE has become such a meme:

    >> If you avoided equities while they were above their historical CAPE measurement, you just missed 24 years of equity gains.
    Hear, hear.
  • @Charles, I know you are a big Meb Faber fan, who in his book Global Value places a great deal of importance on the Shiller CAPE. Meb Faber obviously thinks the Shiller CAPE should play a big role in our investing decisions. The referenced chart shows the Shiller P/E to have averaged 25.1 for the past 25 years. How then do you think investors should use the Shiller P/E in their investing decisions?
  • Hi Guys,

    I’m in davidrmoran’s and Charles’ corner on this issue.

    Yes, the current P/E ratio and/or the CAPE ratio are currently a tad (that’s a scientific measure) on the high side relative to long term averages. But these signals, which according to a Vanguard study do provide a 20-30% explanation of market price movements, are not sufficiently above the norm to likely generate negative equity returns for the upcoming decade.

    They are not in the worrisome zone yet, but warrant some watching.

    Here’s why. I’ll be using the methodology formulated in Chapter 2, On the Nature of Returns, of John Bogle’s classic “Common Sense on Mutual Funds” book.

    Based on current values and historical average data, I expect stock dividends to yield 2% annually, productivity gains to yield a 2% gain, demographics to enhance returns by 1% annually, inflation to contribute about 3%, and since the P/E ratio is nearing a tipping point, I expect a modest regression-to-the-mean to subtract maybe 1% annually.

    Adding these factors together projects an expected 10-year positive 7% annual equity reward. That’s roughly 3% below the long-term returns because of a little muted GDP growth rate (which impacts productivity profits) and a likely slight regression-to-the-mean of the present P/E status.

    Well, that’s my guesstimate. It directly reflects the Bogle long-term returns model, historical data sets, and current parameter valuations. Given the depressed character of current bond performance, stocks still don’t appear to be a bad deal, but also don’t expect the historical average of equity returns. Too bad, but not really too bad.

    Well, that’s my hat in the forecasting ring. Forecasting the next 10-year return is actually easier and more reliably made than projecting next year’s return. I hope this helps.

    Best Regards.
  • MJG said:



    Yes, the current P/E ratio and/or the CAPE ratio are currently a tad (that’s a scientific measure) on the high side relative to long term averages. But these signals, which according to a Vanguard study do provide a 20-30% explanation of market price movements, are not sufficiently above the norm to likely generate negative equity returns for the upcoming decade.

    They are not in the worrisome zone yet, but warrant some watching.

    Based on current values and historical average data, I expect stock dividends to yield 2% annually, productivity gains to yield a 2% gain, demographics to enhance returns by 1% annually........

    Adding these factors together projects an expected 10-year positive 7% annual equity reward.

    1. What is your thinking regarding expecting "demographics to enhance returns by 1% annually....."? One of the biggest demographic issues in the U.S. is "The Graying of America", the aging of America. Substantial numbers of baby boomers retire every day, reducing the overall GDP and productivity, which in and of itself as a factor decreases the profits of corporations. What are the demographic trends you think will add to stock returns going forward?

    2. Re: "according to a Vanguard study do provide a 20-30% explanation of market price movements.
    Do you have a reference to this study, or link/URL? I'm not doubting what you are saying, but would like to read it

    3. Re: 'the current P/E ratio and/or CAPE ratio a tad on the high side relative to long term averages....not in the worrisome zone yet'

    James Montier is a key member on Jeremy Grantham's GMO team, who write their monthly stock market 7-year forecast. The Shiller CAPE is a significant factor they consider.

    James Montier does not agree that the Shiller P/E is a tad high. He says it is exceedingly high.

    In this interview from May 15, 2014: http://money.cnn.com/2014/05/01/pf/stocks-overpriced.moneymag/index.html?iid=SF_M_River

    he is asked:

    Interviewer: "Are stocks overpriced?"

    James Montier: "There is no doubt that the U.S. stock market is exceedingly overvalued."

    Interviewer: "What makes you so sure?"

    James Montier: "The simplest sensible benchmark is the Shiller P/E. Right now we're looking at a broad index like the Standard & Poor's 500 trading at something like 26, 27 times the Shiller P/E. Fair value would be 16 or 17 times historical earnings."



  • edited July 2014
    @MJG

    You noted: "Given the depressed character of current bond performance, stocks still don’t appear to be a bad deal,"
    What evidence do you choose to present regarding "Given the depressed character of current bond performance"; indicating a depressed bond market?
    Is this not misleading at this time for those reading here regarding bond area investments?

    To which or what bond market(s)/sectors do you refer?


    Catch
  • I have been in this business long enough (30 years) to have heard it all, from the perennial bears (like Gary Shilling) who are always calling for a market crash, to the polyannas (too numerous to name), who were bullish even during late 2007 and early 2008. There are advocates for just about every P/E calculation and market valuation process. Most folks can point to these and say "See, this was right!" at some point in history. Most folks are not old enough to remember Elaine Gazzarelli, who "called" the 1987 market crash. Unfortunately, she missed just about everything after that. The same goes for Meredith Whitney who scared muni bond investors to death in late 2010 with her prediction there would be billions in muni defaults. This, of course, did not happen, but she continues to get press and speaking engagements nevertheless.

    Frankly, I don't spend a lot of time delving into Shiller and the other calculations. Remember that averages are just that...averages. Seldom are prices at AVERAGE prices. They are almost always above or below the averages.

    Perhaps a logical response to all of this 'over-priced' and 'under-priced' concern would be to have a portfolio allocation with some built-in safety valves, including some hedging and bonds and cash and truly low-valuation equities, that will cushion any initial selloff and provide time to make rational, not emotional, decisions. We own some funds run by managers who are extremely cautious right now. They are lagging, some by big margins, but that is ok. We expect they will buffer any effects of a correction. And remember that pricing alone seldom results in a selloff. There are always other triggers, political, economic, monetary policy, global events, that are usually the flash points.
  • There are always other triggers, political, economic, monetary policy, global events, that are usually the flash points.
    Look! Eagles!!

    No, wait... those may be swans...
  • MJG
    edited July 2014
    Hi BobC,

    Great stuff! Thank you for joining the discussion. I really liked your general battle plan to protect against a possible market downturn. It’s a plan that is designed to sacrifice a little upside potential to dampen significant downside danger.

    I have always practiced a little defense in my portfolio allocations, probably not as effectively as your professional constructions. Many investors don’t fully appreciate the benefits that a dedicated advisor can deliver.

    I am old enough to remember Elaine Gazzarelli. Not only was she good looking, she was also very smart. Indeed she enjoyed momentary fame and then faded rapidly with a series of misdirected forecasts. Her crystal ball became cloudy.

    She is a committed quant and is recognized as such by the financial industry. Back when she made her famous “call”, Gazzarelli depended solely on a multi-dimensional market correlation model. I seem to remember that the correlation model had about 12 linear parameters. That’s an early danger signal that some data mining might be in play. I challenged her accordingly by email. She graciously replied and we had an energetic exchange that likely profited both of us.

    She still deploys her 12-component market econometric model, hopefully with refined and updated correlation coefficients. I wish her well.

    Best Regards.
  • Hi Guys,

    Sorry for the delay, but I've been captured in some sort of continuous loop when trying to reply on this subject. I can only post a short message.

    Thanks for your enthusiastic interest in my post.

    Here is the Link to the Vanguard study that I mentioned:

    https://personal.vanguard.com/pdf/s338.pdf

    The most powerful weapons in an investor’s arsenal are time and patience. As Charles Ellis observed in 1985, “Time is Archimedes’ lever in investing”

    Best Wishes.
  • MJG
    edited July 2014
    Hi Guys,

    Again, my abridged response to the bond questions follow.

    My bond commentary was simply grounded in historical data considerations, no special insights. Historically, there is a bond returns pecking order: short term government bonds generate about 0,5% annually above inflation, short term corporate bonds deliver 0.8%, long term treasuries produce about 3.0%, and long term corporate bonds reward 3.5%, all reported annually and all incrementally above inflation rates.

    If inflation remains in the 3% range, as postulated in my original posting, even the subdued annual returns projected for equities outdistances likely bond returns. My original statement was based on this simplistic logic.

    The big danger in all these forecasts is the possibility of investor overreaction to unknowable Black Swan world events. Such overreactions destroy forecasts and happen frequently. But the marketplace has demonstrated strong recovery resilience.

    The MFO website refuses to accept my full response.

    Best Wishes.

  • Someone wants you to be pithy.
  • edited July 2014
    >>>The most powerful weapons in an investor’s arsenal are time and patience. <<<

    You are a walking encyclopedia of stock market platitudes. Not a criticism, just an observation. Let's see, when I was approaching my 38th birthday in the spring of 1985 I was unemployed and had around $2200-$2300 in my account. I actually had a negative net worth if you take into consideration credit card debt, etc. Taking your beloved index approach with my account coupled with "time and patience" would put me about where almost 30 years later? Not in a very secure financial situation that's for sure.

    Edit: Stock market platitudes aren't all that bad. For instance, I think the best wealth creation tool out there is the tax free compounding of your capital over time (but please no patience as that leads to subpar returns) You talk to some of the traders on the trading forums and tax free accounts ala IRAs etc are foreign concepts to them.
  • MJG said:

    Historically, there is a bond returns pecking order: short term government bonds generate about 0.5% annually above inflation, short term corporate bonds deliver 0.8%, long term treasuries produce about 3.0%, and long term corporate bonds reward 3.5%, all reported annually and all incrementally above inflation rates.

    @MJG, thanks for the link to the Vanguard study, just saw this post.
    Interesting info about bonds, and the expected return of each category above inflation.

    Very much appreciate if you happen to have a reference for that bond info. I've been looking for that type of info, but haven't found it

    thanks
  • edited July 2014
    @rjb112.

    Yes sir. Meb fan I am.
    How then do you think investors should use the Shiller P/E in their investing decisions?
    Every now and then, I fear Mr. Faber does sound a little like a Cape Crusader. But I think I most align with his preference to find the intersection of value and momentum.

    Aloca AA comes to mind this past year. BAC last couple years.

    If I jump-in on low valuation only, even if I really like the company, I'll have it on a short leash. There is just so much unknown. Always.

    But once the stock gets some altitude, thanks to momentum (be it due to earnings or group think), I'll try to use 200 day or 10 mo SMA. If it dips below that, I'll look to exit.

    If momentum turns a 1 bagger to a 2 bagger to a...10 bagger. I will try to stay with it regardless of valuation and use only momentum to determine whether to remain or exit.

    So, I guess the short answer is: I seem to be most comfortable entering a position when it has both value and momentum, but once established, momentum is the driver.

    That's what seems to be working for me these days. FWIW.

    Hope all is well.

    c
  • Hi Jungster,

    Thanks for joining the commentary.

    I’m not sure if this will disappoint you, but I’m not a “walking encyclopedia of stock market platitudes”. But I do try to integrate appropriate ones into my MFO postings.

    Since I usually document my market prospective with a heavy dose of statistics and academic references, I feel that these posts tend to the dry end of the writing spectrum. I feel that the addition of market wit and wisdom helps to make these posts more entertaining and more enjoyable as well as educational. That’s just my opinion of my own writing style.

    I surely am not an encyclopedia of investment sayings. I get many of them from a Mark Skousen book titled “The Maxims of Wall Street”. I extracted the Ellis quote from Chapter 5 of the Roger Gibson book titled “Asset Allocation: Balancing Financial Risk”. I thought Ellis’ comment was pithy.

    Take care.
  • edited July 2014
    @Charles: thanks for your take on this with individual stocks.
    For someone not purchasing individual stocks, but taking an approach with stock index funds or exchange traded funds, how would you let the Shiller CAPE ratio influence your investing decisions?

    One approach some take is to let the Shiller P/E influence their asset allocation, backing off on equities when the Shiller P/E is elevated. Based on this (Shiller P/E way above long term historic levels of 16.5), some only have 50% or so of their normal allocation to equities right now. Another possible approach is choosing funds that have lower P/E ratios, such as GVAL, the DoubleLine DSENX, the exchange traded note CAPE, investing in the 4 U.S. stock sectors with the lowest Shiller P/Es, and choosing a traditional value fund (based on low P/E and low price/book ratios)

  • Both approaches sound good to me. Suspect one needs to take more of a long term view with funds. As several have pointed out above, valuations can stay above average for quite a while and folks can get frustrated (eg., ARIVX, COBYX). Longer term, I believe value wins out. Here's chart from GVAL book:

    image
  • Hi Guys,

    Sorry for the confusion, but this is my fourth workaround attempt to post. My patience is running thin.

    As you know, I am skeptical of all forecasts. My overarching feeling is that forecasting is at best educated guesstimates with a low likelihood of prescience. Forecasters basically can not forecast. I contributed to this topic more as a fun submittal than as an actionable forecast.

    The big danger in all these forecasts is the possibility of investor overreaction to unknowable Black Swan world events. Such overreactions destroy forecasts and happen frequently. But the marketplace has demonstrated strong recovery resilience.

    I really like Charles Ellis' observation that “Time is Archimedes’ lever in investing”

    Unfortunately, as John Maynard Keynes noted: “The market can stay irrational longer than you can stay solvent”. So don’t fall into that trap; keep a healthy cash reserve. I use the Vanguard short term corporate bond fund as my reserve unit.

    I just discovered yet another meaningful financial axiom. This one is from Warren Buffett: “The difference between successful people and very successful people is that very successful people say “no” to almost everything”. My takeaway is to be judicious when seeking and accepting advice. Don’t be satisfied with unsupported assertions; check and verify the references and the statistics.

    My patience is exhausted so I’ll stop here. Plenty of personal opinions are embedded in all these postings, but that’s what makes a vibrant marketplace. Enough serious talk committed to a supposedly fun exercise.

    I’ll say Good-By for now. I’ve enjoyed most of our exchanges. I look forward to talking with you all further down the road.

    Best Regards and Best Wishes.
  • @MJG always appreciate your thoughts. In terms of dealing with cranky comment boxes, my recommendation is to write your thoughts out in word or some equivalent, then cut and paste however much MFO's comment parser will allow and then chain a few posts together.
  • edited July 2014
    Or maybe just eliminate the excess verbiage. I don't see a whole lot of other folks here complaining. You suppose that might indicate something?
  • I posted last night 9: 30 ish. After hitting post comment, I had a split screen !! Nothing materialized so chose to forget it.
    Derf
  • edited July 2014
    The user and all related content has been deleted.
  • edited July 2014
    "With a major influx of foreign people, call them what you will, flooding into the country, this has a significant impact on the economy. It is hard to quantify, because of the difficulty in knowing the number of people crossing our borders and our inability to track them."

    Now see, because you stopped there it's very easy to agree with you. The whole immigration system is terribly broken, in many, many ways. It's just shameful that congress and the administration cannot sit down and:

    1) agree on a definition of at least some of the issues
    2) explore a range of possible solutions, or if not solutions, at least palliatives
    3) provide enough funding to at least allow proper handling of the statutes already on the books.

    I read somewhere a few days ago that there are some 240 immigration judges in the entire US, compared to some 400 superior court judges in Los Angeles County alone. The laws already on the books, passed by Congress, require that all of those children be given a a court hearing. Thousands upon thousands of children, divided by 240 judges, equals how much time before anything at all gets done? This whole thing is just insane. Enforce the existing laws? Fine. Great. How about some resources?

    Please note that I am not focusing on any particular party here. There's plenty of blame to spread around the whole setup.

  • >> There's plenty of blame to spread around the whole setup.

    oh, I dunno.
  • I'm trying to make a point here without starting any trouble. (Internal personal opinions may differ slightly from text as published.)
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