Email This Article
These days, there’s a cloud of uncertainty over markets, with questions about economic growth, government deficits, the timing and impact of interest rates increases, unemployment levels and the US housing market.
Combined with recent market volatility and disappointing stock returns over the past ten years, it’s no surprise that many investors have lost confidence that stocks will be a good place to be over the mid and long term … especially when they hear respected money managers like Bill Gross talk about a “new normal” of slower economic growth and lower returns on stocks.
The result is that many investors have money earning next to nothing in cash. That’s fine if someone only needs a 1% or 2% return to hit their long term goals — but for many investors, their current allocations mean it will be impossible to achieve their long term goals.
And it’s in this kind of an environment that advisors can bring value, by providing perspective on both sides of the debate about the value that stocks provide at today’s levels.
Expert views on stock valuations
Today, the the leading proponents that stocks are cheap and that they’re expensive are Wharton’s Jeremy Siegel, author of Stocks for the Long Run and Yale’s Robert Shiller, who wrote Irrational Exuberance.
Notably, both went on record in early 2000 to the effect that tech stocks were overvalued and at unsustainable levels — but since then have diverged on their assessments of stock market valuations.
Ten days ago, I travelled to Philadelphia and New Haven and spent an hour with each of Professors Siegel and Shiller, who coincidentally are long-time friends who regularly vacation together on the Jersey Shore.
Our conversations on market valuations are summarized in my column in today’s Globe and Mail, which is at the bottom of this email and which can be sent to clients.
The case for stocks as expensive
Robert Shiller looks at corporate earnings adjusted for inflation over the past ten years — looking back ten years eliminates short term distortions in any given year.
Over the past hundred and fifty year, stocks have traded at an average multiple of sixteen times an average of the past ten year earnings.
Today, stocks trade at around twenty times their average earnings. I make the point in my Globe column that while not close to the peak level of forty times historical earnings they hit in 2000, this is still historically expensive — and suggests returns in the period ahead below the long term levels of 9% before inflation and 6% after inflation.
As an aside, In January I spent 90 minutes with Shiller over lunch, having fortuitously bumped into him at the Atlanta airport. At that time, he made the comment that even when stocks are at 20 times average ten year earnings, investors can still do respectably in the following period.
Today, he is more pessimistic, as he’s concerned that eroding confidence by American consumers and business could lead to a downward spiral of reduced spending, which in and of itself could trigger a double dip recession.
And he concluded our conversation by saying that he’s uncertain whether investors will be better off in stocks or in bonds in the period ahead.
The argument for stocks as cheap
Jeremy Siegel has a very different take on the value in stocks.
In my Globe column, I note that he uses a different method to value stocks and reaches a different conclusion — his analysis suggests that compared to long term averages stocks are undervalued by 25% to 30%.
The biggest difference between his approach and Robert Shiller’s is that his is forward looking, focusing on consensus earnings forecasts for this year and next. Among his criticisms of Robert Shiller’s methodology is that mega-writeoffs such as the $80 billion writedown by AIG will distort the earnings base from which backward looking calculations are conducted for years to come.
Siegel has looked at U.S. stock market valuations over a 200 year period. During that time, the average stock multiple of earnings has been 15 times — that compares with a multiple of consensus earnings forecasts of 13 times for this year and 11 times for next year.
The impact of low interest rates
Siegel’s average of 15 times earnings includes periods of double digit inflation, when multiples are typically depressed — excluding periods of double digit inflation, the average multiple that the market paid for earnings was 17 times.
If earnings forecasts for next year are accurate, then returning to that long term average of 15 times earnings would see stocks increase by 30%, rising to the historical low inflation valuation norm would see stocks rise by 50%.
Addressing the new normal of lower growth
We also discussed some of the arguments by Bill Gross at PIMCO and others about a new normal of slower economic growth, due to deleveraging, re regulation and a reduction in the pace of globalization.
His response was that these are legitimate concerns but that they ignore the impact of innovation and especially the effect of the internet.
Siegel points to the internet as a transformative tool in accelerating the pace of innovation, as scientists and researchers around the world are able to work together in real time.
And he went on to say that this will inevitably lead to faster economic growth.
Communicating your views to clients
In an industry where opinion often drowns out reason, Robert Shiller and Jeremy Siegel stand out for their careful, fact-based approaches.
Which view you and your clients favour will largely depend on your going-in biases — those who are currently negative will look to Robert Shiller’s approach, those who are more optimistic will side with Jeremy Siegel.
The good news is that these two views lay out clear parameters for the upside and downside case for stocks — and provide the foundation for a reasoned discussion about the direction of stocks in the period ahead.
And by sharing the arguments on both sides of the debate with clients, you position yourself as someone who considers all the facts before reaching conclusions and making recommendations.
Two routes back into the market
A final comment on helping clients get back into the market, if after discussing this you agree that it makes sense to increase their stock allocations.
At that point, you can go in one of two directions.
One is to immediately move to the target allocation.
The advantage of making the full move now is that clients will benefit from any run-up in stocks and you won’t have to contend with hesitation to complete the commitment in six and twelve months.
The downside to this approach is that if markets see a short-term setback, you risk heightened anxiety from your client and potentially losing that client entirely.
The alternative is to phase in that move in stages, with perhaps a third now, a third in six months and the final portion in a year.
For many clients this is a more comfortable approach than investing the total amount right now.
Further, by suggesting that you phase in the commitment you reduce the risk of clients wondering about whether your advice is influenced by the desire to earn higher compensation from funds that are invested in the market rather than sitting in cash.
To watch two of the interviews with Jeremy Siegel, click below — note that additional videos are available at www.clientinsights.ca
Why stocks are undervalued:
Responding to market concerns:
About ClientInsights.ca A breakthrough in client communication Not long ago, clients read what you sent them. Today that's changed. In the You Tube world we live in, many investors would prefer to hear from a portfolio manager directly. And instead of reading an article on tax saving or estate planning strategies, more and more Canadians would rather watch an expert discuss the topic. Clientinsights.ca was developed in response to these changes - to deliver information in the form that investors want to receive it. It provides over 150 short video interviews, each about 4 to 6 minutes - you can email them or watch a video along with clients to start a meeting. No matter how you use it, Clientinsights.ca is designed to help you take client communication to a higher level. Dan Richards Founder and CEO, Clientinsights.ca Read more from the author/contributor here.
Tags: Client Confidence, Corporate Earnings, Expert Views, Globe And Mail, Government Deficits, Interest Rates Increases, Irrational Exuberance, Jeremy Siegel, Jersey Shore, Long Time Friends, Market Volatility, Money Managers, Robert Shiller, Stock Market Valuations, Stock Returns, Stock Valuations, Term Goals, Unemployment Levels, Us Housing Market, Wharton
Posted in Dan Richards| Comments Off