Happy Birthday Mr. Bull!

On the first anniversary of the bull market, E.S. Browning looks at the valuation debate between economists Robert Shiller and Jeremy Siegel. Not surprisingly, Dr. Shiller thinks the stock market is expensive and Dr. Siegel thinks it’s cheap.
Both men have held their positions for quite some time. For the last decade, Shiller has clearly won the debate (while Dr. Siegel has made some sloppy mistakes).
Despite Shiller’s accuracy, I’m skeptical of his methodology (after all, a person can be right for the wrong reasons). He relies on the market’s P/E Ratio with earnings going back 10 years. That seems too far for me. Plus, I suspect (both I’m not convinced) that earnings multiples need to be higher compared with decades ago. Shiller is very good at getting tons of data, often from many decades ago, but I’m not so sure such long-term comparisons are helpful. The economy and markets are quite different from the 19th century. Stocks are much safer compared with bonds and that difference should be reflected in valuations.
In fact, higher earnings multiples are nothing new for the market provided that you ignore the inflation racked period from 1966 to 1982. Earnings multiples started to rise in the 1950s and reached very elevated levels in the early 1960s. I think people forget that because the market didn’t suffer a severe reckoning until the 1970s (though there were some painful episodes in between).

Once inflation started creeping into the economy, interest rates soared and earnings multiples took a tumble. However, once Paul “Big Paul” Volcker squeezed inflation from the economy, multiples slowly resumed their climb back to JFK levels. The problem with that analysis, of course, is that you’re adjusting for a heck of a lot of data. So has the normal level for P/E Ratios been around 18 or so for the past 50 years with the inflation era as an aberration? Or are there natural 15 to 20 year periods of multiple expansion and compression? I lean toward the first, but I’m far from certain.
Siegal’s research centers around the fact that stocks have returned 7% a year adjusted for inflation. I’ve used that figure myself many times and it’s interesting to see how we’re doing against the long-term trend. In fact, when you adjust the market’s total return against a 7% trend line, it looks suspiciously like a P/E Ratio chart.
The problem with this method is that it assumes past data is an unbroken trend and all subsequent deviations have been corrected by reversions to the mean. That’s where I hold up a red flag. On top of that, the deviations from the long-term trend are very extreme. If the market can be so vastly out-of-whack from where it should be and for so long, then what’s the point? As an investor, I want to know what looks good right now.
My view is that I’m leery of all market forecasts. I tend to be on the bullish side simply because long-term interest rates continue to be low (Moody’s AAA Corporate Bond Index is currently around 5.2%), the market doesn’t expect a major resurgence of inflation anytime soon (the TIPs spread is fairly quiet) and the yield curve continues to be very wide (all of the market’s capital gains have come when the 3-month/10-year Treasury spread is over 65 basis points—the spread is currently at 355 points).
Still, I’m not investing in the entire market. My advice for investors continues to be to focus on high-quality stocks. The market’s dislocation has left us some bargains. Some of my favorite stocks include AFLAC (AFL), Nicholas Financial (NICK), Dean Foods (DF) and Reynolds American (RAI).

Posted by Eddy Elfenbein on March 9th, 2010 at 10:29 am

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