Tag Archives: Shiller PE

You Can’t Get Blood Out Of A Stone

My title comes from Jeremy Grantham’s recent CNBC interview. This remark occurs in a discussion about likely returns from the U.S. stock market. Everyone at Grantham’s firm, Grantham, Mayo, van Otterloo (GMO), agrees that over the next two decades stocks will deliver around 2% after-inflation or “real” returns, says Grantham himself. Traditionally, the market has delivered 6%-7% annualized real returns, but trying to achieve that now will be like trying to draw blood out of a stone. Investors hoping for the historical 6%-7% are bound to be disappointed.

The reason for Grantham’s pessimism is simple — P/E ratios are high. Grantham uses the Shiller PE (current price of the S&P 500 Index relative to the underlying constituents’ past 10-year average real earnings). The long term average of that metric is around 16, but over the past quarter century is has been over 20. But Grantham doesn’t think the average will return to 16 soon or in a way that value investors want. It will likely take around two decades instead of a more typical 7-year cycle. And, in a way, that’s more painful than having a market crash. A crash amounts to a valuation re-set; prices get cheap, and the opportunity to invest presents itself to those with courage. But a slow movement from a Shiller PE of 30 (where it sits now) to 16 is a real problem for long term investors who won’t get a good opportunity for returns for a generation.

Besides expensive valuations, the economic cycle will not be in investors’ favor. Grantham thinks recent growth numbers reflect a one-time bump of sidelined workers getting back into the labor market from the time of the financial crisis. That increase has produced an aritificial percentage point of growth in recent years, Grantham estimates, which means the U.S. isn’t growing at, say, 2.5%. Instead it’s growing at more like 1.5%. That will be apparent, in Grantham’s opinion, as the last workers who were frightened out the labor market after the crisis re-enter. Perhaps that game of re-entry can persist for a few more years, Grantham speculates, but it’s not a permanent feature of the economy. When it ceases, growth will suffer.

Moreover, population growth in the U.S. is declining. We need a 2.1 fertility rate to keep growing, and the U.S. has a 1.76 fertility rate. Also, the fertility rate is below that in every other developed country. The population growth rate in the developed world “has gone to hell,” says Grantham. Only emerging markets countries present the prospect of stronger population growth. Besides a growing population in emerging markets, Grantham is also impressed with China’s emphasis on engineering and science education. China is beginning to dominate Artificial Intelligence and green energy, for example. India isn’t far behind, and, when pressed to single out a country that might be the single best investment in the emerging markets space, Grantham singled out India. Even if Grantham is uncomfortable making a specific country call, all of this means he thinks emerging markets are the future for equity investors. It’s a given, however, that emerging markets investors will have to endure volatility.

Grantham is less keen on Europe. Population growth is worse there than in the U.S., and the recent problems with immigration will only worsen, stressing the EU considerably. And a weakened EU grants more opportunity to China and Russia to misbehave. It also increases uncertainty. Brexit looks like it might be delayed, and when it’s delayed it looks like the odds of overturning it might increase somewhat. Still, Grantham provides no guarantees regarding the country of his birth.

While population growth — or lack thereof — present problems for the economy, at least it’s beneficial for the planet. Grantham has devoted time and resources to combat global warming and harm to the environment. Grantham proudly drives a Tesla, but noted that, as a value investor, he wasn’t interested in the company’s stock. He did allow that the stock could be successful, as Amazon’s has been.

The message investors should take from Grantham’s remarks is that stock returns in the developed world will be low for the next decade and possibly longer. That means you must increase your savings rate to meet your retirement and other goals. The market probably won’t do the heavy lifting that it’s done in the past.

Morningstar’s Christine Benz On Return Forecasts

Baseball Hall of Famer and sage, Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” But, as Morningstar’s Christine Benz notes, plugging in a return forecast is necessary for financial planning. Without it, it’s impossible to know how much to save and for how long. In this spirit, Benz has collected asset class return forecasts from large institutional investors and Jack Bogle, who is virtually an institution himself.

Because the forecasts are longer term, they are worth contemplating even if you can’t take them to the bank. Nobody knows what the market will do this year or next year. But it’s at least possible to be smarter about longer term forecasts. When you start at historically high valuations for stocks, such as those that exist now, it’s reasonable to assume future 7- or 10-year returns might be lower than average. In fact, the S&P 500 has returned less than 5% annualized (in nominal terms) since 2000 when it had reached its most expensive level (on a Shiller PE basis) in history. That’s only half of it’s long term average.

Below are the forecasts in table form and in bar chart form as Benz reports them. Some are nominal, and some are real; we’ve indicated which kind after the name of the institution.

At least two of the asset managers’ forecasts — GMO and Research Affiliates — take the Shiller PE seriously. That metric indicates the current price of the S&P 500 relative to the underlying constituents’ past 10-year real average earnings. When that metric is low, higher returns have tended to result over the next decade. And when it has been high, low returns have tended to result. Currently the metric is over 28. It’s long term average is under 17.

Investors should take all forecasts with a grain of salt. But when valuations are as high as they are now, it seems prudent to lower expectations.

Are Tech Stocks Cheap?

Are technology stocks cheap? It seems like a strange question to ask as the market drops on news that Apple has indicated weaker future sales. I also doubted whether Facebook’s price reflected its business value in the middle of this past summer. I thought fair value for the business was around $140 per share assuming it could grow its free cash flow by a robust 6% annually over the next decade. The stock is now in the $130 range after pushing higher than $200 in the early summer.

But technology isn’t just the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google). And at least two important firms – DoubleLine and GMO – think the sector is at least relatively cheap. Here’s why.

First, technology is trading cheaply on a Shiller PE basis, shown by the fact that the DoubleLine Shiller Enhanced CAPE Fund (DSEEX) holds the sector. By using a bond portfolio as collateral, this fund gains exposure to an equity derivative that delivers exposure to four of the five cheapest S&P sectors (tossing the one with the worst one-year price momentum) on the basis of their Shiller PE ratios — and technology is one of those sectors currently. The Shiller PE, as a reminder, is the current price of a stock, sector, or index relative to its past decade’s worth of real, average earnings. Right now (and for more than a year) technology has come up as one of the four sectors the fund owns, meaning its Shiller PE is lower relative to its own historical average than other sectors’ Shiller PEs are to theirs. The other sectors the fund owns currently are Healthcare, Consumer Staples, and Communication Services.

This mechanical application of the Shiller PE may not satisfy investors looking for more a more absolute definition of value, but, relative to other sectors, technology is cheap on a serious valuation metric. If you’re going to be allocated to U.S. stocks in some way, shape, or form, this is a reasonable way to achieve that allocation.

Second, GMO, which is also a fan of the Shiller PE metric, and uses it in its asset class valuation work, also likes technology stocks. The Boston-based firm just published a white paper, written by Tom Hancock, the head of the firm’s Focused Equity Team, arguing that technology stocks were attractive. The firm’s “Quality” strategy has 45% of its assets in technology stocks, “including positions in three of the five FAANG stocks.” Alphabet (Google) and Apple are the two largest holdings of the firm’s Quality mutual fund (GQETX), managed by Hancock.

Rather than relying on traditional valuation metrics when picking individual stocks, the firm looks at how Alphabet, for example, invests in R&D, and how that investment can translate into higher future revenues. In other words, R&D isn’t properly counted as an expense that will never yield future revenue and earnings growth. On the basis of accounting adjustments like this, GMO views Alphabet as a cheap stock.

Hancock notes that GMO’s Quality portfolio doesn’t trade at traditional valuation multiples that are different from the broader market. But, “in an expensive market, quality companies typically trade at higher P/E’s than most ‘value’ investors would like.” Higher multiples are justified for companies with resilient margins and strong business models, and Hancock thinks the strategy can produce returns of 5% in excess of inflation.

Quality companies in the U.S. are also cheaper than those outside of the U.S., and Hancock surmises that’s because of a kind of scarcity value. Companies with consistently high margins and returns on invested capital are less prevalent outside of the U.S., so they trade at dearer prices.

Moreover, the U.S. technology sector consists of a diverse group of stocks. Only one of the FAANGs – Apple – is in the top-10 of the S&P 500 Information Technology Sector. Some of the largest constituents of that sector are the darlings from the technology bubble of nearly 20 years ago – Microsoft, Intel, Cisco, and Oracle. They turned out to be good businesses that were just overpriced then. Hancock lists Microsoft’s virtues as being in the cloud growth business and having a lock on the consumer. Qualcomm, by contrast, has a unique position in the smartphone supply chain, while Oracle provides legacy software and benefits from high switching costs. Finally, Visa and Mastercard are “borderline tech” companies, but, nevertheless, find themselves near the top of the S&P 500 Information Technology sector.

So, despite being known for top-down asset class valuation calls, the GMO Quality strategy is bottom-up and fundamentally oriented. And, just like the more mechanical, single-factor approach of the DoubleLine fund, it also finds technology stocks cheap – or cheaper than their brethren in other sectors.

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Both the DoubleLine Shiller Enhanced CAPE fund and the GMO Quality III fund are worthy of investors’ consideration. Beware that the latter is for institutional investors, given its $10 million minimum. Get in touch with us if you have questions about portfolio construction, asset management, or financial planning.

Lessons From Thanksgiving Dinner

Talking to friends and family at Thanksgiving dinner made me realize how unprepared for volatility investors are. The gathering I attended was filled with a wide mix of investors, from the young and novice interested in technology stocks and (somehow still) in Bitcoin to older, seasoned veterans. The veterans, however, didn’t exhibit much more savvy than the novices; everyone was spooked by the recent volatility.

Based on my Thanksgiving Dinner experience, here’s what I think investors need to learn now.

Re-Set Your Expectations

First, I think investors are spooked because they are being unduly influenced by the market action of 2017. But that was an unusually calm year that saw a 22% gain in the S&P 500 without a down month. That’s a Bernie Madoff-like performance — straight up every month like clockwork with no hiccup to the downside. That kind of performance usually only occurs when someone makes it up. Investors should realize that 2017 is an anomaly and that volatility is part of investing. Financial markets are rarely that smooth and stable. Do your best to expunge 2017 from your memory.

Below is a monthly chart of how the S&P 500 Index performed in 2017 and for the first 10 months of 2018. It may surprise you to see that the index was still in positive territory at the end of October. A $100 investment in the index at the start of the year was still worth more than $102 on Halloween. As of this writing (Nov. 23), the index was still in positive territory, albeit barely ((0.19% for the year, including dividends).

I don’t point out that the market is still positive to give investors encouragement to take more risk though, or to argue that markets have delivered solid returns this year. I do so in order to impress on you that large cap U.S. stocks are still positive, and that your sense of markets might be warped. This year feels awful to investors, but the returns really haven’t been bad. There’s a disconnect between the year’s returns and what the year has felt like. That’s because 2017 was so strange in the index posting positive gains for every month.

Reconsider Your Allocation

I also don’t mean to encourage investors to think they can time markets perfectly. The point is not to dance in and out of stocks adroitly, missing losses and capturing gains; it’s having an allocation that gives you enough of the upside and allows you to live with the downside without shaking you out of your investments. If the recent volatility makes you want to sell, chances are you have too much stock exposure, or you have to re-calibrate your expectations from financial markets.

I think most investors I meet with have more stock exposure than they can handle. Or at least they strike me as being badly prepared for declines either because they don’t have advisors or because they have incompetent advisors who don’t disclose risks and historical volatility. When declines come, many of them will bail out at or near the bottom despite the fact that Morningstar’s most recent “investor return” numbers suggest investors are getting better at mistiming markets. Instead of falling into that trap you should reassess your allocation now, before any damage has occurred. That’s not a prediction that a crushing decline is around the corner; I wish I could be that clairvoyant. But you should always be prepared for one. And you should have an allocation that encourages you to buy after a big market decline, not sell.

Hold Extra Cash, But Avoid Bunker Mode

Having just given all those warnings about market timing, I still think it’s fine to hold some extra cash. Every reasonable market valuation metric, including the Shiller PE and Tobin’s Q, is flashing expensive. None of these indicators are good at forecasting short term market moves; markets can get (and have been) more expensive. But they are good are forecasting the next decade’s worth of returns. Returns will likely be low from current valuations. That means holding some extra cash is warranted. But, for goodness sake, don’t go to 100% cash with long term assets, thinking you’ll time your reentry perfectly. The paradox of sidestepping a decline is that if the market crashes, there’s a good chance that you’ll feel so good for having missed the decline that you’ll have a lot of trouble getting back in. But 10% or even 20% more cash or shorter term U.S. Treasuries than usual for long term assets isn’t unreasonable either.

Are Stock Multiples Moving Targets?

Many observers dismiss, or at least question, the market’s rise since around 2013 as mere “multiple expansion.” That means the prices of stocks have risen disproportionately to underlying earnings, and either prices must decline or earnings must catch up in order to return to some normal or historically average PE multiple.

In a recent blog post, serving as the latest installment of “stockbroker economics,” Barry Ritholtz argues that all bull markets involve multiple expansion. (We accept Andrew Smithers’ definition of stockbroker economics – 1. All news is good news. 2. It’s always a good time to buy stocks.)

Using a chart from Mark Lehmann at UBS, Ritholtz asserts that all bull markets consist of rising PE multiples. The chart also shows PE rising overall in recent decades. The implication (it’s not really a fully formed argument) is that those who distrust the market rally of recent years as mere multiple expansion don’t realize that all bull markets involve multiple expansion.

There’s multiple expansion and there’s multiple expansion

It seems reasonable and not that surprising that all bull markets involve multiple expansion. But what would make Rittholtz’s post more complete is if it asked what kind of expansion is reasonable and what kind isn’t. For example, using the Shiller version of the market multiple, is the PE moving from single digits, or from 10 to 20? Or is it moving from 20 to 30? Or is it moving to 44 as it did in the late 1990s? Investors should want to know that, but Ritholtz doesn’t mention it.

Perhaps Ritholtz thinks all prices are “random walks” and that nobody can say what is a reasonable price to pay for stocks and what isn’t. But he doesn’t say that, and the reader is left wondering what he thinks about that important question. Does the market get prices right, and deliver inflation-beating returns to long term investors over, say, every 10-year period? We don’t know from reading the post.

What about the upward trend of PE ratios from the 1980s? Is that justified or not? It is possible to comment or make an argument about that. After all, investors like Rob Arnott and Jeremy Grantham, who organize the portfolios they manage around valuation have implied recently that it might be too rigid to treat historical averages as immutable. But we don’t know what Ritholtz thinks. All we know is that Ritholtz doesn’t make an argument. He only gestures in this direction.

When reading Ritholtz’s post, one is reminded of the ancient Greek philosopher, Cratylus, who thought language was inadequate to describe reality. Appropriately, Cratylus wound up moving his finger instead of speaking. I don’t know what Cratylus would say — or motion — about a Shiller PE of 32. Cratylus was a student of Heraclitus who thought the world was always in flux and that nobody could “walk into the same river twice.” According to Aristotle, Cratylus said you can’t even walk into it once. Maybe there’s a new normal, or even an ever-changing normal, for stock multiples, but advisors should think hard if they’re going to bet on that with clients’ money.

If you think your advisor isn’t assessing risks adequately, please click the link above to schedule an appointment and tell us which article drove you the link.

Is Your Target-Date Fund Too Risky?

If you’re planning to retire in or around 2020, and you have most or all of your assets in a target date fund, is that fund too risky? It might be given current stock market valuations.

I recently published an article on how various allocations served a hypothetical investor retiring in 2000. Any backtest begun that year would admittedly be unflattering to stock exposure, but retirees must think in worst-case scenarios because they are at risk of running out of money. And stocks may not be much cheaper now than they were in 2000.

In that article, I used the following chart to show how each hypothetical portfolio performed using the so-called 4% retirement rule, whereby the retiree withdraws 4% from his account in the first year of retirement, and boosts whatever the dollar value of that initial withdrawal by 4% each year thereafter.

It turned out that a pure stock portfolio couldn’t withstand the 4% rule given the amount of declines in two bear markets – from 2000 through 2002 and in the 2008-early 2009 period. The original $500,000 would have declined to a little more than $100,000 in the 18 year period. A balanced portfolio did much better; it would be down to a little more than $400,000. A still more conservative portfolio – 30% stocks and 70% bonds – would have remained intact. In other words, the more bonds a portfolio had, the better it held up despite the fact that stocks outperformed bonds on a compounded annualized basis – 5.4% for stocks  versus 5.1% for bonds.

And now most 2020 retirement funds have more than 50% stock exposure, potentially setting up their investors for a bumpy ride and loss of capital. On our list of some of the largest funds with 2020 dates, only the American Funds offering and the JP Morgan entry have less than 50% stock exposure.

Stocks reached a Shiller PE (price relative to the past decade’s average real earnings) of 44 in 1999, and they are at 32 now. The 44 reading seems far away, but, besides that extravagant reading during the technology bubble, the metric has been over 30 only one other time – in 1929.

Moreover, the median stock, on a variety of valuation metrics, is more expensive now than it was in 2000. For example, GMO’s James Montier recently showed that the median price/sales ratio is higher now than it has been in any other time in history. During the technology craze, small cap value stocks and REITs, for example, were left for dead, and investors prowling for cheap stocks could buy them, and wait. They wound up delivering boffo returns for the next decade. From 2000 through 2009, when the S&P 500 Index delivered no return, the Russell 2000 Value Index delivered an 8.3% annualized return to investors. But now there are arguably no cheap parts of the market.

Valuation metrics aren’t crash predictors; they don’t tell you a crash will occur next week, next month, or next year. But it’s reasonable to anticipate that the higher valuation metrics go, the more likely a significant decline or significant volatility become. And big declines hurt retires withdrawing from their accounts dramatically.

It’s also true that foreign stocks are cheaper, but they’re not that cheap. GMO’s most recent asset class return forecast shows no region of the world is poised to deliver inflation-beating returns. That means target date funds may be putting their client assets unnecessarily at risk. In 2013, Jack Bogle argued that target date funds were too heavily weighted in bonds, potentially crimping investor returns. With a Shiller PE above thirty and bond yields creeping up, the opposite might be the case now.

Financial planner and author Michael Kitces has shown that the Shiller PE works well as a financial planning tool, indicating what future returns stocks might deliver over intermediate time frames — around 8-18 years. Though a bit short on details, Kitces argues that the metric can help retirees facing sequence of return risk by encouraging them to adjust their spending. But it’s unclear why the metric can’t influence gentle portfolio modifications as well. When the Shiller PE is over 30, the likelihood of robust returns — or even returns that can beat bonds, despite low yields — is diminished after all. Nobody should ditch all their stock exposure; markets can always surprise investors. But retirees face such a harsh outcome if their portfolios suffer big declines during the first decade of retirement that modest stock exposure — even less than 50% stock exposure — appears the most prudent course. Unfortunately, judging from their allocations, target date funds may not be aware of the risk they’re imposing on their shareholders.

Target date funds are allocated based on investors’ distance from their spending goals. Even setting aside the difficulty of the retirement spending goal, which run over years and decades, distance from goal shouldn’t be the only consideration in answering the allocation question. Target date funds should also consider valuation and sensitivity to volatility.

The Two Rules Of “Stockbroker Economics”

How an advisor should talk to clients and what rhetoric leads to big sales are often at odds. It can be death to an advisory business if the advisor is negative. Clients tend to want reassurance from an optimistic advisor. That’s why economist Andrew Smithers refers to broker happy talk asstockbroker economics.”

The two rules of stockbroker economics are:

1. All news is good news, and;

2. It’s always a good time to buy stocks.

On the role of news, a strong economy fills clients will all the optimism and willingness to buy that they need. A weak economy simply prompts a broker to say that falling interest rates and future rising profits are good for stocks, never mind that profits and prices had only moved in tandem 54% of the time when Smithers wrote his 2006 article. On the second rule, nothing has succeeded as well as what Smithers calls the “bond yield ratio,” another name for which is the “Fed Model.” That model compares bond yields to the earnings yield of the stock market (the reciprocal of the P/E ratio or E/P). This ratio worked from 1977 to 1997, but didn’t from 1948 to 1968. Using the full dataset shows no relationship between bond yields and earnings yields, according to Smithers.

Other forms of nonsense used to support the second rule include using a current P/E ratio to appraise stocks. Of course, a current P/E ratio has little ability to forecast long-term returns. It sometimes shows stocks are expensive when they are actually cheap, and vice versa.

A third piece of nonsense that Smithers doesn’t mention is the assertion that all forecasting is bunk. While forecasting next year’s returns might be bunk, metrics like the Shiller PE and Tobin’s Q have strong records in forecasting future long-term returns. Even if the Shiller PE has been elevated for the past 25 years, the S&P 500 Index has delivered tepid returns (5.4% annualized) from 2000 through 2017 with the entirety of that return occurring only in the last 5-years.

All of this means the first rule for investors judging their advisors is whether their advisors engage in too much happy talk – especially about future returns. If an advisor says a balanced portfolio should deliver a 7% annualized return for the next decade with starting 10-year U.S. Treasury yields at 3% and stocks at a 32 CAPE, be wary.

Second, investors should avoid advisors who avoid making forecasts to the point where they disparage anyone who does. That’s because it’s not hard to make a bond forecasts. With high-quality bonds, yield-to-maturity will get you close to the total return. Although stocks are harder, the Shiller PE can help. And, the more it’s stretched by historical standards, the more accurate it gets. No advisor should be dogmatic about pinpointing future returns; anyone who thinks they can be precise is crazy. But it’s also outlandish to expect long term historical returns from the stock market when valuations are as stretched as they are today. Stock market forecasts are hard, but don’t let your advisor squirm out of them completely.

Making a forecast is also necessary for constructing a financial plan. And, while it’s true that an accurate forecast doesn’t have to be available just because advisors and clients need one, decade-long projections are easier, if imperfect, than guessing what next year’s market move might be. When the Shiller PE stretches to more extreme levels, low future returns become more likely. So, when you hear an advisor making fun of something, that should raise warning flags.

We think advisors with integrity aren’t afraid to tell clients stocks are expensive even when it might hurt the advisor’s business. An advisor constructing a financial plan owes you an honest assessment of future returns. Currently, the Shiller PE is at 32. And while nothing is impossible, it’s very unlikely that stocks will deliver more than a 2% real annualized return for the next decade.

Third, consider if your advisor goes beyond the risk questionnaire he gives you. Nearly every financial advisory firm has a risk questionnaire that it gives to prospects and clients. The questionnaire often has many questions about how much risk the investors think they can handle and what portion of their assets they’d like to put at risk in exchange for possibly getting a higher return than a low risk investment will deliver. But risk questionnaires ask about percentages, and most people don’t think in percentages. Consider if your advisor asks you how you might feel if you opened up your statement and your account was down by a certain dollar amount. That’s more meaningful than a percentage question. Consider it a positive thing if your advisor pursues this line of questioning a bit, including asking you how you felt and how you reacted to the market plunge in 2008.

Risk often boils down to how much of a portfolio decline a client can tolerate before selling out, and everyone has a point at which they sell. This is important because it shows how investors do themselves damage. The tendency should be to buy stocks when they get cheaper, not sell them. But investors rarely think of buying when the prices of their holdings are declining.

Advisors have other ways of trying to train clients about how to treat price declines in their portfolios. Many advisors focus on long–term asset class returns, trying to persuade investors that they can overcome declines if they have the willpower to stay the course and not be discouraged. Other advisors do the opposite, focusing on how severe declines can be and trying hard to get clients into allocations that they can live with at the outset and to prepare them for the difficulty that lies ahead in the inevitable downturns.

The advisors who emphasize long term returns often come close to shaming clients into owning stocks. In my experience, such has made some clients feel inadequate for not wanting to assume more risk – or have encouraged clients to take more risk than they would have for fear of being deemed inadequate in the eyes of the advisor. Make sure your advisor isn’t shaming you into owning more stocks than you can handle.

At Clarity Financial, we focus on the growth of savings and on the minimization of emotional duress that can lead to poor investment decision-making.

It’s Okay To Hold Some Cash

The great sage and baseball legend, Yogi Berra, once said:

“It’s tough to make predictions – especially about the future.”

But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.

The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.

The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.

Hope for a correction? Move some money to cash?

Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.

Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.

Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)

If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.

These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.

Don’t Be A Victim of Recency Bias

Is it possible that stocks aren’t overpriced? Financial adviser Josh Brown raises the possibility, arguing that earnings can grow into their prices. After all, Amazon, Netflix, and Nvidia have seemed overpriced to investors for a long time, but their economic performance keeps improving. As Brown puts it, with all of these stocks in the recent past, “[t]he fundamental stories grew up to justify the valuations investors had already been paying (Brown’s emphasis).”

And this can also happen to entire markets. Five years ago, the market’s cyclically adjusted P/E ratio (CAPE or Shiller PE) was higher than it had been in 87% of all readings up until that point. But the stock market has been up 90% since then. “No one could have known that the fundamentals would arrive to back up the elevated valuations for stocks eventually,” according to Brown.

This last statement is odd. In May of 2013, the S&P 500 carried a CAPE of 23. Now its CAPE is 31. It’s not clear from this simple valuation metric that stock earnings have grown into their new, elevated prices. Past ten-years’ worth of earnings ending in 2013 were $78, according to Robert Shiller’s data. For the most recent ten-year period, they are $84. Ironically, one could make the argument that earnings have grown into the 2013 price five years later, but not the 2018 price. It we apply the May 2013 price to the past decade’s worth of earnings ending today, we get a CAPE of around 21. That’s much more reasonable than the current one of 31.

In fact, if we agree that the long-term historical average CAPE of nearly 17 is outdated, and that the new average should be around 20 or 22, then the 2013 price of the market relative to the past decade’s worth of earnings ending today is roughly the correct valuation. That also means all the price advances the market has made since 2013 do not reflect underlying economic reality or earnings power value of the market. In other words, earnings have increased, but stock prices have increased much more so that the market should be trading at 2013 prices given the past decade’s worth of earnings.

Brown’s point, of course, is that the earnings growth of the past decade can repeat over the following decade. But that also means that for stocks to deliver robust returns, the current 31 CAPE valuation must reappear 10 years from now. That’s possible, but investors and advisers must contemplate how they would like to bet and what they must tell clients if they are behaving as fiduciaries.

It’s possible that we could wake up to a 31 CAPE in a decade, and that U.S. stocks will have delivered 7% or so nominal returns (2% dividend yield plus 4%-5% EPS growth). It’s also possible that earnings-per-share can increase at a greater clip than they have historically. Nobody should say those things are simply impossible. But if you are managing your own money, or advising others in a fiduciary capacity (which means you must treat their money with all the care you do your own), how reasonable is it to expect that as what forecasters might call a “base case?” At best, assuming we’ll all wake up to a 31 CAPE in a decade must be a very rosy, low-probability scenario.

There’s an irony to Brown warning against those who carry on about backward looking valuation metrics. One of the most well-known observations of behavioral finance is that human beings can be seduced by recent patterns, including recent securities price movements. We tend to assume, without any evidence other than the recent pattern, that price trends will continue. Everyone will have to decide for themselves whether deriving encouragement from a 90% stock price move without a commensurate earnings increase, as Brown does, reflects proper attention to simple arithmetic or our susceptibility to extrapolate recent stock price movements and returns into the future.

A Recession Says Nothing About Future Stock Returns

(Thanks to Morningstar’s John Rekenthaler for including one of my emails to him in a column consisting of reader reponses while he tended to his wife who, as he reports, suffered a fainting spell. We wish both of them well, of course.)

Do we need a recession or another credit event similar to 2008 to tell us stocks are overpriced and cause them to tumble? John Rekenthaler of Morningstar seems to think so. I sent him an email in response to an article he wrote doubting the verdict of recent bubble-callers like GMO and Research Affiliates. I said stocks were objectively expensive (using the Shiller PE), and that meant future returns would likely be low.

But John thinks that a turn in the economic cycle will determine a downturn in the stock market, and tell us, after the fact, if stocks are overpriced. Since we don’t know when that will occur or what it will look like, we must remain agnostic as to the future returns of the stock market. As he responds to my email in a new article:

“One of these years the economic cycle will turn, thereby making projected corporate earnings wildly overstated rather than moderately so. Stocks will get crushed. If that happens in 2018 or 2019, then equity prices will indeed have been high, and returns will indeed be low. If the economy holds out until 2020 or longer, though, then today’s values should look reasonable.”

Unfortunately, while stock markets tend to tumble when the economy goes South, since the Great Depression there’s scant evidence that single recessions tell us anything about how stocks are priced or indicate anything about their future 10-year returns. For that all-important forecast, one must consult starting valuations more than recessions or moment in the economic cycle.

Consider the 50% decline the S&P 500 Index suffered from 2000 through most of 2002. The recession in 2000 was minor. In fact, it didn’t’ even meet the standard definition of two straight quarters of GDP contraction. GDP contracted in the second quarter of 2000, then again in the fourth quarter of that year, and never again.

Did that recession warrant a 50% price reduction in stocks? Did it somehow prove that stocks were overpriced? Or were stocks just wildly overpriced to begin with, as the Shiller PE hit 44 in early 2000?

The point isn’t that we may or may not have a recession over the next 2, 3 or 5 years. The point is stocks are at a Shiller PE seen only twice before in history – 1929 and the run-up to 2000. Come recession or not, over the next decade investors in the S&P 500 will capture a 2% dividend yield. They may also capture 4%-5% earnings-per-share growth. That puts nominal returns at 6%-7%, which isn’t bad at all. Unfortunately, the third component of future returns consists of where the future PE ratio will sit. Will the Shiller PE maintain itself above 30? Or will it contract to something resembling the historical average of nearly 17? Even if that average is outdated, is the new norm 32? Or is it more like 20 or 22?

Whether a recession comes within the next 5 years or not has little to do with these questions. And though it may send stocks down for most of its duration, it ultimately will have told us nothing about longer term returns compared to how much starting valuation can tell us. In fact, the two features of the Shiller PE are that it’s based on a prior decade’s worth of earnings and is pretty good at forecasting the next decade’s worth of returns. It’s not based on short-term earnings, and it’s not good at forecasting short-term stock returns. A recession doesn’t matter one whit insofar as it’s a typical part of a full cycle that the Shiller PE aims to capture in its earnings calculation and in its stock return forecast.

It’s possible we might wake up in a decade to a 32 Shiller PE. And it may have remained there all along, or it may have arrived there again as the result of any number of gyrations. The question is what should financial writers be telling their readers (and financial advisers telling their clients) about that possibility?

Projections Are Imprecise, But Not Useless

It seems banal to say, but financial planning requires return projections or estimates. If you’re saving money for a goal like retirement, sending a child to college, buying a home, or taking a vacation, you need to know three things (at least) — how much to save, how much of a return that savings will earn, and the distance to the goal. Without any of those three things, there can’t be a plan. And all of this doesn’t take into consideration your own temperament or how you react to volatility and the potential for permanent loss.

Of course, the return projection won’t be precise if any part of the capital is being invested in stocks. It’s not easy to forecast how much stocks will return over a given time, and the shorter the distance to the goal the more unpredictable and random stock returns are. And that’s one reason stocks shouldn’t be used for short-term financial goals. They can do virtually anything over one- or two-year periods of time. However, over longer time frames — 7-10 years or more – forecasts can be more reasonable, though still not precise. But one is never absolved from making an estimate or a range of estimates.

Unfortunately, some prominent financial planners, who often double as pundits, denigrate all forms of forecasting. Financial planner and sometimes New York Times columnist Carl Richards recently tweeted that the only thing we know about projections is that they are wrong. He applied the hashtag “projectionfreeplanning,” which, of course, is an oxymoron. There’s no such thing as financial planning or projecting a future value of an investment, after all, without a return estimate.

Similarly, prominent advisor and pundit, Barry Ritholtz, has argued that forecasting is “almost useless” and that we “stink at it.” Ritholtz says assertions like “stocks tend to go higher” are vague enough to be exempted from his critique, but “The Dow will hit 25,000 by the second quarter of 2018” aren’t. What’s frustrating about his writings is that they don’t say anything about the ordinary forecasting of long term (say, 10- or 20-year) returns financial advisors must do to satisfy future value calculations for their clients.

The pundits like to say that the Shiller PE isn’t a valid metric anymore because it’s been well over its long-term average – around 16.5 – for over 25 years. But the annualized return of the S&P 500 Index, including dividends has been 5.4% from 2000 through 2017, and the Shiller PE was over 40 in 2000. In other words, in 2000, it did a good job of telling investors future returns would likely be tepid. Moreover, that return has depended on the dazzling 15% return of the index since the financial crisis that has driven the Shiller PE up again to the low 30s. And, as Rob Arnott has said, we can have a reasonable argument about whether the new normal for the Shiller PE is 20 or 22, but not whether it’s 30.

Advisors are rebelling so much against forecasting because they don’t like to deliver bad news to clients. Bad news can be bad for business. Clients will choose the advisor with the highest future returns projections because they want to be soothed. But delivering optimism when it’s unwarranted can lead to projections that border on malpractice on the part of the advisor. Investment professionals usually know this when it comes to bonds. It’s difficult for a bond or a portfolio of bonds to return more than its yield-to-maturity. However, when it comes to stocks, advisors often resort to using the longest term return numbers they can find. Those usually come from Ibbotson Associates, now a division of Morningstar, which popularized a stock market return chart dating from 1926. But most investors aren’t investing for a century, and there have been enough 10- and 20-year periods of poor returns to give investors and advisors pause. More importantly, those periods are associated with high starting valuations.

And now it has become clear that estimating, say, 7%, for a balanced portfolio over the next decade is a stretch. Bonds are likely to deliver less than 4%, and that means stocks will have to deliver more than 8.5%. Advisors are becoming increasingly pessimistic about that possibility for stocks, but they aren’t responding by expressing that pessimism clearly Instead, they are responding by bashing forecasting altogether. It’s not the most mature response, but the possibility of losing clients because of poor forecasts has its bad effects. And it’s true that the Shiller PE — or any other valuation metric — isn’t perfect in forecasting returns, but it can’t be prudent to count on stocks delivering 8.5% for the next decade with a starting Shiller PE in the low 30s.

Investors should question their advisors about returns, because they need to know how much money their current savings rate will leave them with to spend in retirement. The return assumption is just that — an assumption — but that means investors can ask for a range of assumptions to see what different returns will deliver. That doesn’t mean the optimistic assumptions are truer ones though, but it helps investors understand what they’re up against without being precise. And that is far from useless. The second thing investors should do is something financial journalist Jazon Zweig discussed in an old column – they should ask their advisors how much return the advisor would deliver to the client in a “total return swap,” whereby the client hypothetically hands over their entire portfolio and gets an annualized return on that portfolio in exchange. There’s no better way to put the screws to your advisor when it comes to getting his or her opinion on future returns.

Divorced From Reality: Prices & Fundamentals

There are many ways of assessing the value of the stock market. The Shiller PE (price relative to the past decade’s worth of real, average earnings) and Tobin’s Q (the value of companies’ outstanding stock and debt relative to their replacement cost) are likely the two best. That doesn’t mean those metrics are accurate crash indicators, or that one can use them profitably as trading signals. Expensive stocks can stay expensive or get more expensive, and cheap stocks can stay cheap or get cheaper for inconveniently long periods of time.

But those metrics do have a good record of forecasting future long-term (one decade or more) returns. And that’s important for financial planning and wealth management. Difficult though it is sometimes, everyone must plug in an estimated return into a formula for retirement savings. And if an advisor is plugging in a 7% or so return for a balanced portfolio currently, he or she is likely not doing their job well. Stocks will almost certainly return less than their long-term 10% annualized average for the next decade or two given a starting Shiller PE over 30. The long-term average of the metric, after all, is under 17.

Another way of looking at how expensive the market has gotten recently is to look at sales of the S&P 500 constituents and relate it to share price. Companies are always manipulating items on income statements to arrive at a particular earnings number. Recently, record numbers of companies have supported net income numbers with non-GAAP metrics. That can be legitimate sometimes. For example, depreciation on real estate is rarely commensurate with reality. But it can also be nefarious, as Vitaliy Katsenelson recently argued in criticizing Jack Welch’s stewardship of General Electric, which Katsenelson characterized as being more interested in beating quarterly earnings estimates rather than in creating long-term wealth. And that’s why sales metrics can be useful. They are less easily manipulated.

So I created a chart showing sales per share growth and price per share growth of the S&P 500 dating back to the end of 2008. From the beginning of 2009 through the end of 2016, companies in the index grew profits per share by nearly 4% annualized, a perfectly respectable number for a mature economy. But price per share grew by a whopping 14.5% over that time. Over that 8 year period, sales grew less than 50% cumulatively, while share prices tripled.

Anyone invested in stocks should worry about this chart. How do share prices get so divorced from underlying corporate sales? One likely answer is low interest rates. But there must be other reasons because we’ve had low interest rates and low stock prices before – namely in the 1940s. That was after the Great Depression, and stocks were still likely viewed as suspect investments. Today, by contrast, stocks are not viewed with much suspicion, despite the technology bubble peaking in 2000 and the housing bubble in 2008. Investors still believe in stocks as an asset class.

And yet, the decline in rates over the past four decades has been breathtaking, as has Federal Reserve intervention. James Montier of Boston asset manager, Grantham, Mayo, van Otterloo (GMO), has studied stock price movements over the past few decades and found that a significant percentage of upward price movements have occurred on or before Federal Open Market Committee (FOMC) days. Montier estimated that 25% of the market’s return since 1984 has resulted from movements around FOMC days. Moreover, the market has moved higher regardless of what the FOMC decision was.

If this is a stock market bubble – and the data shows unusually high prices relative to sales and earnings – it is a strange one. One doesn’t hear the anecdotal evidence of excitement – i.e., cab driver’s talking about their latest stock purchases, etc…. This is perhaps a kind of dour bubble, where asset ownership at any price seems prudent in an economy that is becoming less and less hospitable to ordinary workers. Or, as Montier wrote in a more recent paper, this may be a “cynical” bubble where investors know that shares are overpriced, but think they can be the first ones out when the inevitable decline begins.