Stock Market Premia, or, Everything Old is New Again
I don’t like talking about stocks. I believe the market is rigged, that the allocations do not favor the investor who is not also a senior executive of the company and/or a member of the Board of Directors, and that reported profits and losses on a quarterly basis is a lousy way to run a company. And those are the moderate objections on a good day.*
That said, I have occasionally commented at Marginal Utility on the wisdom of investing in stocks. When not citing this article, I often reprint a graphic from Burton Malkiel’s A Random Walk Down Wall Street:
This one is fairly easy to explain: when P/E multiples are running high in the market, mean reversion tends to happen. No allocation requirements, no changes in attitude or latitude at the drop of a FedFunds rate: just reasonable odds of whether you will make money on the investment.
(Doesn’t mean you won’t make money, just means it’s “the way to bet.”)
So it comes as little surprise when Felix cites “a handy tool” by Rob Bennett “based on one of Robert Shiller’s favorite indicators, P/E10, or price to previous ten years’ average earnings”:
Right now, P/E10 is at about 22, which mean that stocks are expensive, by historical standards: Rob reckons that fair value, for stocks, is about 14 or 15, and that anything above 20 is “truly dangerous”:
There have been three occasions when we have gone to P/E10 levels above 20. On those three occasions, the average loss in the years that followed was 68 percent. So the general rule is to lower your stock allocation when the P/E10 level goes above 20.
Felix goes on to note several catches that amount to “past history is not necessarily a predictor of future events”:
For one thing, I just don’t think that many investors have anything like the requisite amount of patience needed – where you can happily sit back for a decade or two waiting for the P/E10 to come down to the mid-teens before going overweight equities.
And for another thing, I’m far from convinced that the behavior of the stock market a century ago, when both the world and corporate capital structures were very different from how they look now, can really teach us much about stock-market investing. I don’t believe that the stock-market asset class has rules which govern its long-term behavior, and I can easily believe that we will never again see the S&P 500 trading on a P/E10 of less than 15. (It’s already been 20 years, and I certainly don’t believe that discount rates are likely to go back up to their 1988 levels any time soon.)
But in the end, his argument comes down to the core issue of investing:
I’ve worried for a while that stocks aren’t an attractive asset class any more. The problem, of course, is that there’s not very much in the way of alternatives. And in any case, according to Rob, if I put all my money in stocks today, I can expect a real return of 5.65% over the next 30 years; 4.65% would be unlucky. I’d be happy with that, I think.
If you want to know why we occasionally get speculative bubbles in various markets, there may be no better explanation than that paragraph.
*I have no problem with the Churchillian assertion that it is “better than all others,” but taking that as a sign of encouragement requires a Pollyannaish, or at least DeLongian [PDF], temperament.