Stocks, Bonds and Another Market High


This indecision’s bugging me . . .
Should I Stay or Should I Go now?
If I go there will be trouble
And if I stay it will be double
Timeless words from 80’s band, The Clash

After a sleepy first quarter, global markets showed considerable signs of life in the second quarter, with many equity asset classes posting returns between 4% and 6%. Outliers included the Nasdaq (up only 2% for the quarter) and Emerging Markets (up 11%). Despite the Dow Jones Industrial Average and the S&P 500 both reaching new all-time highs in June, European and Pacific stocks outperformed the US. US small caps were the one notable negative, down a fraction of a percent for the quarter. As we’ve come to expect of late, bonds posted very modest returns, with government bonds – both short and intermediate durations – posting returns of about one-half of a percent for the quarter. High quality comparable maturity corporate bonds produced returns that were in the same range.

US economic data was strongly positive for the quarter. May new home sales (504,000) blew past expectations and were up almost 19% from April, the highest rate of increase since May of 2008. Aggregate hours worked climbed over 3.7% annualized through May; jobless claims remain low; consumer confidence is near a business cycle high; industrial production climbed 5% through May, and core capital goods orders are up 5.8%. All in all, very good news. Markets completely shrugged off the negative Q1 GDP report that came out in the last week of June, probably for three reasons. The first was that it was “old” Q1 data; the second is that it’s generally recognized that horrible Q1 weather had a notably negative impact on that quarter’s economic activity; and the third reason being that a big part of the Q1 GDP dip was health care spending, with numbers likely being a bit perverted by the Q1 rollout of the Affordable Care Act. Perhaps, the brightest piece of news is late June’s Consumer Confidence number, which is both at its highest absolute level in some time and also finally at a point where more consumers are saying the economy is good as opposed to bad.

And so, with every bit of positive news, comes a new set of worries; namely, are stocks too expensive? I’ve heard this question in several forms over the last year, and especially this past quarter. Perhaps the most talked about measure of (over)valuation is the Cyclically Adjusted Price-to-Earnings ratio (also known as the CAPE ratio or the P/E 10 Ratio). This has been widely popularized by Yale economist Robert Shiller, who regularly tracks and publishes this metric, but only for US stocks, on his website. In a CNBC interview in late June, he noted that the ratio had just crossed the 26x mark, which is quite high by historical norms. In that same interview, he noted that he was still invested in the market but “was thinking of pulling back a bit”, then equivocating by adding, “It’s really hard to forecast the market. It might continue this boom. But on the other hand, it is looking really high.” Noted.

So, how helpful are valuation metrics at predicting what the market might do next? Not very, and especially not in the short-term. In May, when the CAPE ratio had just hit 25x – almost equally expensive by long-term norms, this provoked another flurry of discussion around ‘what this might mean’. At that time, Deutsche Bank economist Stuart Kirk noted that while 25x was, in fact, high, it was also that high in 1995 and 2003. In the four years following 1995’s worrisome CAPE level, the market would go onto add another 141% before meeting the buzzsaw that was 2000. Likewise, in 2003, the market would go onto add another 41% through 2007 before the crisis of 2008-2009.

Several years ago, Vanguard published a very worthwhile paper looking at the value of several market metrics, including the CAPE ratio, for predicting subsequent one-year returns. Unequivocally, the CAPE ratio was the biggest winner, with a CAPE / 1-year return correlation of 0.43, which means that about 43% of the subsequent year’s returns could be explained by the CAPE ratio. However, that also means that 57% of the next year’s return was not explainable by the CAPE ratio. It is probably also worth noting that the CAPE ratio continued to signal “expensive” in the months following the March 9, 2008 market lows, from which we are now up more than 150%. Shiller himself has said that the CAPE ratio is not a good timing tool, and is probably better used as a way to set expectations around what subsequent longer-term market returns might look like, with higher CAPE ratios today yielding lower expected future returns, and lower CAPE ratios yielding higher expected future returns.

Given the preceding, what does the CAPE tell us then, and what does that imply for investment policy? First of all, given the very strong five years we’ve had – even coming off of the 2007-2008 financial crisis – I don’t think it’s unreasonable to expect more modest returns, especially from US stocks, which have been the biggest of the winners over the last five years. More modest returns might materialize in a couple of ways: a significant market dip – which should never really be a surprise since it’s just part of the equity experience – followed by more “normal” market returns; or perhaps no major dip, but a period of lower, less exciting returns for a multi-year period. While neither is guaranteed to happen, both are entirely plausible.

Secondly, it’s worth remembering that “equities” are not a unified asset class. There are large companies and small; US and foreign; European and Pacific, etc. Most of the metrics that say “high-by-historic-standards” apply to US markets, with European, Pacific, and especially Emerging Markets, being much more in line with long-term historical averages. If I were a betting person, I would say it’s reasonable to expect better returns over the next five years from non-US holdings than from US-based holdings, and this is why we diversify. For most of our clients, somewhere between 40% and 50% of their stock holdings have been and are presently in international, non-US equity markets, and so while these have had the effect of muting returns over the last five years, they may very well have the effect of buoying returns over the next five.

Perhaps more importantly than just the question of “are equities high” is the question of “what’s the alternative?” Although US equity prices are high by some historical measures, most notably the CAPE ratio, it is entirely possible – perhaps even probable – that despite these valuations, they are still the better bet as compared to bonds with their record low yields and cash, with its also record low returns. While the appeal of timing the market is unmistakable, in my 20 years’ worth of experience, it’s a siren song that almost unequivocally leads the boat onto the rocks and is seldom, if ever, rewarded. Putting aside the temporary pain – and it always has been temporary for those who haven’t panicked out – of the inevitable market corrections, the longer term benefits that accrue to the patient equity investor have historically rewarded – and amply so – the disciplined, patient and long-term focused investor, retired or otherwise.

I hope you are enjoying the summer so far and continue to do so. Please let us know if you have any questions or if there is anything we can do for you.