Wednesday, October 29, 2008

A Little Perspective

There was a balanced piece in the NY Times today debating whether or not stocks are really "cheap" at current prices. If you buy into the fact that the last 20 years has been a bubble of unprecedented proportions, where the explosion of cheap credit fostered a false economic reality, then perhaps you can see a period of time where stocks retreat even further.
No one can predict short-term swings (we're probably about 1 1/2 from another wild ride) but the long-term trends are a little easier to identify.
Some of the country’s most famous investors, including Warren Buffett and John Bogle, have started to make the case that it’s time to dive back into the stock market.
But there is another argument that deserves more attention than it has gotten so far. It is based on numbers and history, and it has at least as much claim on reason as the bullish argument does.
It goes something like this: Stocks are truly cheap only relative to their values over the last 20 years, a period that will go down as one of the great bubbles in history. If you take a longer view, you see that the ratio of stock prices to corporate earnings is only slightly below its long-term average. And in past economic crises — during the 1930s and 1970s — stocks fell well below their long-run average before they turned around.
To make matters worse, corporate earnings have now started to plunge, too. Assuming that they keep dropping, stocks would also need to fall to keep the price-earnings ratio at its current level.
The 10-year price-to-earnings ratio tells an incredibly consistent story over the last century. It has averaged about 16 over that time. There have been long periods when it stayed above 16 and even shot above 20, like the 1920s, 1960s and recent years. As recently as last October, when other measures suggested the market was reasonably valued, the Graham-Dodd version of the ratio was a disturbing 27. But periods in which the ratio has jumped above 20 have always been followed by steep declines and at least a decade of poor returns.
By 1932, the ratio had fallen to 6. In 1982, it was only 7. Then, of course, the market began to self-correct in the other direction, and stocks took off.
After Tuesday’s big rally, the ratio was just a shade below 16, or almost equal to its long-run average. This is a little difficult to swallow, I realize. Stocks are down 40 percent since last October, and every experience from the last 25 years suggests they now have to bounce back.
But that’s precisely the problem. Since the 1980s, stocks have always bounced back from a loss, usually reaching a high in relatively short order. As a result, the market became enormously overvalued.

How attractive are the alternatives? Savings accounts and money market funds will struggle to keep pace with inflation. Bonds may, as well.
Stocks, on the other hand, are paying an average dividend of about 3 percent, which is better than the interest on many savings accounts, and stocks are also almost certain to rise over the next couple of decades.
I would just point out that dividend payouts are almost certain to be sliced in the coming year so that 3% yield will probably fall.

No comments: