A look through the eyes to two distinguished professors, Nobel Laureate Robert Shiller of Yale and Jeremy Siegel of the Wharton School of the University of Pennsylvania.
Stocks closed mixed on Friday in a relatively quiet session with no significant news. Trade concerns continued to weigh on markets. Over the weekend, the Trump administration suggested it was ready to move ahead quickly to institute 10% tariffs on an additional $200 of goods coming from China. China, for its part, has said it will respond in a measured way that could include some restrictions on exports to the United States. So far, nothing is firm. But trade talks at higher levels has subsided as the bickering intensifies. Trump more than likely doesn’t want to see a material adverse impact on the U.S. economy or prices before the mid-term elections but he clearly wants to continue to sound tough and motivate his base. With the exception of U.S. trade representative Robert Lighthizer, Commerce Secretary Wilbur Ross, and trade czar Peter Navarro, there are very few politicians or economists who believe that trade tariffs are beneficial economically. Perversely, if China were to restrict trade to the U.S., that would lower our imports from China and “improve” our balance of trade. If that makes sense to anyone, send me an email. In the meantime, however, the actual tariff damage done to date has been relatively small and has hurt only a small minority of companies. The stock market, therefore, has had muted reactions to the heightened rhetoric waiting to see an actual negative economic response before selling. Whether the outcome of the elections would impact trade talks and the outlook for tariffs is open to conjecture. Not considering myself politically savvy, I will leave that judgment to others.
Switching gears, two of the most prominent academicians when it comes to security prices, are Professor Robert Shiller, a Nobel Laureate currently teaching at Yale, and Professor Jeremy Siegel of the Wharton School of the University of Pennsylvania. Professor Shiller, is the cautious one of the two. His book, “Irrational Exuberance”, published in early 2000 just before the Internet bubble burst and now in its third edition, focuses on a concept called the CAPE ratio. CAPE stands for cyclically adjusted price earnings ratio. It is a ratio of the current price to the inflation adjusted average earnings per share over the last 10 years. Because earnings generally increase, using a trailing 10-year average will produce a CAPE ratio that is a bit higher than using a traditional Price-Earnings ratio. Dr. Shiller uses data going back about 150 years and derives an average CAPE ratio of a bit over 16. Today, according to Dr. Shiller that ratio is well over 30. You don’t have to be a math genius to reach a conclusion that Dr. Shiller finds stocks overpriced today.
Professor Siegel looks at the market differently. He believes that stocks, over the long run, using data going back to the 1820s, have historically returned average returns of 6% adjusted for inflation. Both professors agree that stock prices and earnings over the long term are highly correlated but that one can get ahead of the other over a relatively short period time. Dr. Siegel admires the concept of the CAPE ratio but finds flaws. Some years ago, the Financial Standards Accounting Board (FASB) adopted a concept of mark-to-market requiring companies to adjust asset values annually to market. But assets could only be written down. Any appreciation of assets could only be realized for accounting purposes when the asset was sold. There are other accounting issues that bother Dr. Siegel including how intangibles are amortized or written off. Finally, when S&P compiles composite earnings, it adds the earnings of all 500 companies together without any consideration for market capitalization for individual companies. If one accepts Dr. Siegel’s adjustments, then the CAPE ratio today would be barely over 21 and, once the Great Recession years of 2008 and 2009 drop out, the number falls further. Therefore, while he doesn’t find stocks particularly cheap today, he believes they are fairly priced.
But Dr. Siegel, who Wall Street views as permanently bullish, does tone down his enthusiasm. He is less optimistic on earnings beyond 2018 than market consensus. He believes growth going forward will be about 3.5% with about 2 ½ points of that growth coming from stock buybacks. Add in about 2% for dividends, and his outlook today is for 5.5% growth long term versus 6%. How does he square that circle? In two ways. First, the law of large numbers suggests that growth rates cannot be sustained at historic rates forever. We have heard that same thought before from Warren Buffett, among others. Second, he notes that the cost of trading has dropped precipitously over the past 20 years as commissions have fallen along with lower ETF expense ratios. Thus, the 5.5% future growth is equivalent to a 6% historic return if one adjusts for trading costs.
Ah, but back to Dr. Shiller. He points out that, historically, there have been periods when earnings spike and stocks move in line and periods when earnings spike have happened with barely a budge in stock prices. For example, around World War I, earnings surged related to war expenses but stocks did not response. Once the war ended, the two realigned. To him, that made sense as war related profits would not be sustainable once the war ended. But just a few years later, after a recession in the early 1920s that coincided with 2
the collapse of the German economy and the value of the mark, we entered the Roaring Twenties, perhaps the first time in the century when there was a period of irrational exuberance. Stocks rose sharply in the 1920s and gave it all back, and then some, when stocks crashed and bad Hoover fiscal policies, including the infamous Smoot-Hawley trade tariffs, precipitated a full-blown depression. But the peak in euphoria was saved for the late 1990s when the Internet bubble reached its peak. Stock prices got extreme and early in 2000, both Professors Shiller and Siegel were quick to warn of danger ahead. While stocks subsequently fell by more than 40% from peak to trough, the accompanying recession was very mild. In other words, it could have been much worse.
Shiller was bearish again in 2007 but, as Dr. Siegel points out, the CAPE ratio has been sending cautious signals for almost 25 years with the once exception of the market bottom in 2008-2009. He thinks that accounting differences cause this. In his view, if one is going to use GAAP earnings to calculate market equilibrium, the resultant average CAPE should be more in the upper 20s than 16-17.
Let’s summarize and apply this to today. Neither would label today’s market cheap but Dr. Siegel is perfectly happy with a 5.0-5.5% total return. He would say to stay invested. By Dr. Shiller’s calculation, the forward return over the next 6 years would be closer to 1%. He believes that strong market of 2017-2018 doesn’t consider that the benefits from tax cuts and fiscal stimulus are short term in nature. That implies that stocks and earnings will realign as earnings growth moderates. That suggests at least some period when stock prices retreat. He isn’t predicting a major bear market nor is he predicting economic calamity. Both professors stayed away from making specific economic judgments. Both recognized that rising deficits and rising interest rates do constitute a threat but went no farther. Both also note that their models are long term in nature; the shorter the time frame, the less useful their work becomes. Putting this all together, one comes to an obvious set of conclusions. Wearing optimistic glasses, stocks can continue to chug along in line with earnings. That suggest returns over the next few years, assuming no recession should be fairly normal. But if one thinks stock prices have moved too far based on short term factors like tax cuts, some modest-to-moderate correction lies in the not to far distant future. Neither suggests that stocks are favorable for the long term although Dr. Shiller would predict that somewhere over the next five years, investors will have to pay for some level of euphoria tied to the tax cuts. Given the outlook for bonds and cash, the alternatives aren’t particularly attractive. While neither talk about individual stocks, it is clear that the enthusiasm in the market is concentrated in certain sectors and, in a market correction, those sectors would be most vulnerable.
All of this is comforting in a way but any real movement in the market probably has to have an economic root or two whether it be a tariff war, a spike in inflation, or problems elsewhere around the world (e.g. China). There are reasons to be watchful but, so far, there is little economic evidence of storms any time soon. Third quarter earnings will be robust and both corporations and consumers are quite optimistic at the moment. Generally, Q4 is kind to equity investors, especially in a strong year. Thus, I expect continued strength for the next several months.
Today, India’s Prime Minister Narendra Modi is 68. Chef Joe Bastianich is 50.
James M. Meyer, CFA 610-260-2220
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