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Here's hoping stocks simmer

Sensible investing is dull. The market never is.

War in Iraq? A three-year bear market? Bond yields at a four-decade low? Like any prudent investor, I try to shrug off the turmoil and dutifully shovel money into stock and bond mutual funds.

That doesn't, however, stop me from analyzing the market action with all the fervor of an over-caffeinated Wall Street strategist. I wouldn't bet serious money on the resulting insights. Still, for what they are worth, here are my three contentions about today's stock market:

Stocks have become less risky, and that's a mixed blessing.

Stocks aren't cheap and may never be again.

Stocks could rally strongly, but I wish they wouldn't.

With war raging in Iraq and the Standard & Poor's 500-stock index still 43 percent below its March 2000 high, it might seem odd to suggest that stocks are less risky. But let's face it, neither the U.S. economy nor world affairs are nearly as volatile as they were in earlier decades.

Think about it: Today's economic turmoil is nothing compared with the Depression of the 1930s or the stagflation of the 1970s. Similarly, the current Middle East conflict, terrible as it is, pales next to Vietnam, Korea and World War II.

Today's greater stability is reflected in stock prices. Even after a three-year bear market, stocks are still pricey based on market yardsticks like dividend yield and share-price-to-earnings multiples, or P/Es in Wall Street parlance. Those rich valuations suggest investors don't view stocks as horrendously risky.

If your biggest fear is another big stock-market drop, this is good news. Apparently, we aren't going back to a world where stocks trade at 10 or 12 times earnings and yield 3 percent or 4 percent in dividends.

But if your goal is to earn healthy double-digit gains, the news isn't nearly so good. Historically, stock investors have enjoyed dividend yields that have averaged 4 percent and benefited from rising P/E multiples, which have added over a percentage point a year to long-run stock returns.

But with stocks now yielding less than 2 percent and priced at around 30 times reported earnings for 2002, you won't make much from dividends and you are unlikely to see a big rise in P/E multiples. The implication: In the decade ahead, stocks probably won't match their historical 10.2 percent return. That is the average annual return since year-end 1925, as calculated by Chicago's Ibbotson Associates.

"The guy who is sitting down today with his retirement calculator and plugging in 10 percent for stocks is making a huge mistake," contends Clifford Asness, managing principal of New York hedge-fund manager AQR Capital Management.

Asness figures that, if you "normalize" earnings and thus smooth out some of the bumps caused by the economic cycle, stocks are at roughly 20 times earnings. That is well above the historical average P/E of 15. But Asness, who loudly proclaimed that stocks were overvalued in late 1999 and early 2000, doesn't think stocks are going back to 15 times earnings.

Why not? It could be that stocks are now less risky, as I suggested above. Alternatively, it could be that stocks were underpriced historically and that the impressive gains since 1925 reflect a one-time bonus, as stocks became more rationally priced.

"If 15 times earnings were too good a deal historically, then you don't have to go back to 15," Asness argues. "I think 20 is a nice fair number. At 20, I think you'll get a real (after-inflation) return over the next 10 years of 5 percent and a nominal return of maybe 7 percent or 8 percent."

Even if we average 7 percent or 8 percent a year over the next decade, that doesn't mean we will get that return every year. In fact, I think there is a good chance we could see a big market rally.

It isn't just that the economy seems in decent shape and that investors might celebrate a victory in Iraq by bidding up stock prices. There are three other reasons share prices could soar.

First, stocks look like a bargain compared with bonds. "I think stock prices still seem a little high, especially given the uncertainties of the world," says Larry Swedroe, research director at Buckingham Asset Management in St. Louis. "But because bond yields have come down so much, that dramatically increases the relative attractiveness of stocks."

Second, contrary to conventional wisdom, stocks usually aren't deeply undervalued at the end of a bear market. Andrew Engel, a senior research analyst at Leuthold Group in Minneapolis, notes that three-quarters of the bear markets since World War II bottomed when stocks were close to average valuations. "We think the stock market looks pretty attractive right now," he says.

Third, bear markets often end with a rip-roaring rally, with share prices soaring 30 percent or more over the next 12 months. Will that happen this time around? Sure, a nice big stock-market rally would soothe investors' nerves and bring relief to many folks, especially retirees who are living off their portfolios.

But I am not living off my portfolio. Instead, I am dutifully shoveling money into stock and bond mutual funds. I would much prefer to keep buying at today's depressed stock prices. Another bull market? As far as I'm concerned, heaven can wait.