I spent much of the Thanksgiving holiday pondering the current state of markets. All asset categories (stocks, real estate, bonds, etc.) have risen dramatically in price in the current economic expansion. Current stock prices, overall, seem to be particularly expensive.
As a matter of convenience, most market professionals use the S&P 500 index as the measure of the “market”. One popular measure of the valuation of this index is the Shiller P/E ratio. This ratio was constructed by Nobel Prize winning economist Robert Shiller. The Shiller P/E takes the inflation-adjusted ten-year average earnings for the index. Dividing the current index level by the adjusted earnings gives the Shiller P/E. The Shiller P/E adjusts for profit fluctuations caused by the business cycle. At the time of this writing, the S&P 500 index had a Shiller P/E of 31.5. This means that an investor buying a fund which replicates the S&P 500 index is paying $31.5 for every $1 in cyclically-adjusted earnings. This is a level only exceeded at the heights of the dotcom bubble.
Many financial thought leaders, including Warren Buffett, have suggested that the current low inflation / low interest rate environment justifies at least this level of stock prices. In other words, relative to bonds the S&P 500 earnings yield of around 3% (found by inverting the Shiller P/E) is attractive relative to the 2.3% interest yield on the 10-year note. Using trailing twelve-month earnings instead of cyclically-adjusted earnings, the earnings yield on the S&P 500 is approximately 5%. The relative attractiveness of stocks over bonds is enhanced if you believe that corporate earnings will continue to climb.
While the current level of stock prices may be justified, depending on one’s view of the direction of interest rates, many financial commentators believe that current prices levels will likely lead to future returns much lower than those achieved in the past. This has enormous implications for savers and investors who are relying on common stock appreciation to provide for their financial futures.
Earlier in the month, Chris and I attended the American Association of Individual Investors’ annual conference, which gave us an opportunity to hear presentations from many financial thought leaders. Citing the continued performance shortfall of most investment managers, many of these experts recommended a passive investing approach, also known as indexing, or a quasi-passive approach using “factor-based” Exchange-Traded Funds. As one conference attendee put it, “the message of this year’s conference is to give up.”
Given the momentum of the S&P 500, it looks like the self-proclaimed “objective empiricists” of index investing will claim another performance victory for 2017. However, many of the index investing proponents fail to state that an investor in an index fund is mitigating against underperformance, but is not reducing the risk of exposure to a pricey market. On a related note, many of the more prudent investment managers which we follow are holding large portions of their portfolios in cash, fearing exposure to pricey equities. Only time will tell if they are right.