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Irrational Despondence? by Bob Lincoln From the Summer 2008 issue of Values "Past performance does not guarantee future results” is the mantra in bold type on almost all mutual fund prospectuses. Yet recent past performance and economic trends are perhaps the most relied upon criteria for investors as they choose among investment options. In our current environment of poor stock market returns and dismal economic performance, many investors are naturally pessimistic about future stock returns. However, as suggested by the maxim above, reliance on recent history can prove treacherous when choosing investment strategies for the present. We believe that is especially so today. Despite the prevailing grim mood generated by recent trends, we believe the outlook for stock market today is quite good. Our positive view derives from an analysis of longer-term investment returns and their relation to longer-term economic trends.March 2008 marks the eighth anniversary of the “irrational exuberance” stock market peak, when the Standard & Poor’s 500 index reached 1527 and the NASDAQ Composite index touched 5048. Stockmarket returns had averaged over 25 percent for the previous five years and many investors, once again relying on recent performance, expected this trend to continue for many more years. Optimism led to an unprecedented valuation as measured by the price/earnings ratio for the market as a whole, which was amplified for large growth stocks and astronomical for dot-com companies that had yet to make a profit at all. In hindsight, investor dreams of continued market gains seem almost delusional. At the end of the first quarter of 2008, the Standard & Poor’s 500 was 1323 and the NASDAQ was 2279. The average return for the Standard&Poor’s 500 was just 1 percent for the eight years ending March 2008, the small positive return a result only of the dividends paid since prices were still lower than eight years earlier. The NASDAQ index remains more than 50 percent below its year 2000 peak. What went wrong? We don’t think you can blame the economy. True, we experienced a modest recession in 2001. On the whole, however, the economy has performed well, and certainly in line with historical averages. Over this eight-year period real growth averaged 2.6 percent, inflation 2.4 percent, and earnings for the Standard & Poor’s 500 grew 5.6 percent per year or about 50 percent cumulatively. Stock market returns were therefore poor because the valuation investors placed on earnings fell sharply, not because earnings themselves were poor. Over this time period the price/earnings ratio of the S&P 500 declined from 28 to 16, or more than 40 percent. The result: The stock market moved from a period of extreme overvaluation of earnings to what we believe is today a substantial undervaluation of earnings. Our empirical research shows that the appropriate price/earnings ratio depends (inversely) on interest rates, inflation, and profit margins. In thecurrent environment, our quantitative models estimate that the fair value price/earnings ratio is 18, indicating that stocks are approximately 12 percent undervalued. This provides opportunity, both because stock prices tend to converge on fair value, which would indicate a rise, and because the current valuation environment provides a cushion should earnings decline. Of course, we recognize that today’s economic environment is precarious. Barely perceptible growth, increasing unemployment, falling housing prices, unprecedented high oil prices, and difficult credit markets all plague the equity markets.The probability of recession is high—in fact we think it is likely that the National Bureauof Economic Research (NBER), the official judge, will determine sometime later this year that a recession began in early 2008. For all these reasons, markets are unlikely to rise sharply in the short run, and another bout of selling remains a near-term possibility. Still, given today’s valuations, we believe that long-term market prospects are quite good. Even assuming a recession this year, the “blue chip” consensus five-year forecast by leading economists calls for real growth of 2.5 percent, with inflation of 2.2 percent. We estimate that in such in an environment corporate earnings would grow at a 6 percent pace and a fair price/earnings ratio five years from now would be 18.5. Such an outcome would produce annualized total returns for stocks of 11 percent, which is quite a good result and surely one not much anticipated in the prevailing mood of pessimism. With some help from moderating oil prices and stronger growth, results could be even better. Certainly, if the economy performs substantially worse than these forecasts, market returns are likely to be less rewarding. There is some danger that inflation could be higher if the commodity price boom continues, or that growth could be lower if current credit problems put a long-term crimp on spending. Even so, disappointment of this sort would be cushioned by the positive effects of starting from a position of earnings undervaluation. That is, unless we experience the dreaded 1970s combination of slow growth and high inflation—“stagflation.” This would indeed produce a very bad stock market outcome, not because of profit growth, which would actually be bolstered by inflation, but because the price/earnings ratio would likely continue to decline. If growth averages 2 percent over the next five years but inflation averages 5 percent and interest rates rise to 6.5 percent, we could envision a future price/earnings ratio of 12.5. This scenario would result in a stock market return for the next five years of only 1.5 percent, more or less a repeat of the disappointing market results of the past eight years. We consider this bleak scenario unlikely. Our judgment is that today’s worries are well reflected, indeed overestimated, in a lower-than-appropriate price/earnings ratio for the stock market, just as the “irrational exuberance” of eight years ago produced too high a price/earnings ratio. If we are able to muddle through the current economic difficulties and experience moderate growth and inflation over the next five years, stock returns are likely to prove surprisingly rewarding. |
