Rebuilding client confidence in stocks

Wednesday, July 21st, 2010

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​.cli​entin​sights​.ca

Why stocks are undervalued:

http://​cli​entin​sights​.ca/​v​i​d​e​o​/​j​e​r​e​m​y​-​s​i​e​g​e​l​-​w​h​y​-​s​t​o​c​k​s​-​a​r​e​-​u​n​d​e​r​v​a​l​u​e​d​/​t​y​p​e​:​i​n​v​e​s​tor

Respond­ing to mar­ket concerns:

http://​cli​entin​sights​.ca/​v​i​d​e​o​/​j​e​r​e​m​y​-​s​i​e​g​e​l​-​r​e​s​p​o​n​d​i​n​g​-​t​o​-​m​a​r​k​e​t​-​c​o​n​c​e​r​n​s​/​t​y​p​e​:​i​n​v​e​s​tor

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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
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