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Wall St. Faces Skeptics: Some analysts expect disappointing gains in the next five years as they say stocks are again too expensive. (Tom Petruno, January 3, 2005, LA Times)

It has become an article of faith for Americans that equities are the best place to invest money for the long haul. That was reinforced in the 1980s and 1990s as stocks rose with relatively few interruptions. The blue-chip Standard & Poor's 500 index produced an average annualized return of 17.9% during those two decades.

But some market pessimists say those results were so good, they in effect stole returns from the future. The prices stocks hit in the 1990s, in other words, already reflected their potential well into the current decade, according to this view.

Steve Hochberg, chief analyst at Elliott Wave International, a Gainesville, Ga.-based financial advisor, contends that the market's dive from 2000 through 2002 — when the S&P 500 plunged 49%, the worst decline since the Great Depression — was the beginning of a long period of poor or negative results from U.S. shares.

The partial rebound in prices in 2003 and 2004 just revived the main argument against stocks, Hochberg said: They're too expensive relative to companies' underlying earnings and given the risks facing the market and the economy.

The average S&P 500 issue sells for about 18 times estimated 2004 operating earnings per share, according to Standard & Poor's in New York. Operating earnings exclude one-time gains or losses.

Shares were much more expensive at the market's peak in early 2000. Viewed historically, however, "stock valuations are too high" again, Hochberg said. "Bull markets just don't start from these levels." [...]

Brian J. Gladish, a 56-year-old software engineer from Long Beach, says he has been worried for a long time that the government's willingness to run up the budget and trade deficits would eventually trigger a crisis that would be ruinous for the U.S. stock market.

Most of his investments, he said, are limited to gold-mining stocks and foreign shares. [...]

Wall Street optimists say blue-chip shares' weak performance since 1997 might be good news, because it could indicate that the market already has purged itself of most of the excesses of the boom years.

Some also say it's a mistake to focus too much on the past.

Ted Bridges, a principal at money management firm Bridges Investment Counsel in Omaha, said that as investors look to the future, they compare how the market might perform against the alternatives, including bonds, bank accounts and real estate.

And looking out five years, Bridges said, stocks are "as attractive as anything else out there."

What's more, people who invest on a regular basis, such as through 401(k) retirement plans, have made money on at least part of their portfolio this decade because they were buying as the market declined from 2000 through 2002, analysts note.

If the market falls again in the next few years, regular purchases of shares could pay off once prices recover again, in this decade or the next. And in the case of stocks that pay cash dividends, investors would be collecting that income along the way.

Bullish analysts also point out that, although many blue-chip and technology stocks have been hit hard since 2000, investors have earned hefty returns in this decade in small-company stocks, energy shares, financial-services stocks and real estate-related issues, among other market sectors.

"There's always a bull market somewhere," said Maxim Group's Ritholtz.

From a fundamental view, the stock market ultimately is a bet on an expanding economy and rising corporate earnings, both of which are still intact, said Robert Morris, director of equity investments at Lord Abbett & Co., a Jersey City, N.J.-based money manager.

"I don't see a force that is powerful enough to stop the body in motion," he said of the economy.

Like Bridges, Morris said stocks had to be viewed "relative to what else you can get for your money." Even mid-single-digit returns, he said, could beat the alternatives in the second half of this decade.

Robert Schiller, hardl a bull, would seem to disagree with Mr. Hochberg, Price-Earnings Ratios as Forecasters of Returns: The Stock Market Outlook in 1996 (Robert J. Shiller, 7/21/96)

The theory that the stock market is approximately a random walk does not look right at all: Figure 1 is a (log-log) scatter diagram showing for each year 1901-1986 the ratio of the real Standard and Poor Index ten years later to the real index today (on the y axis) versus a certain price-earnings ratio: the ratio of the real Standard and Poor Composite Index for the first year of the ten year interval, divided by a lagged thirty year moving average of real earnings corresponding to the Standard and Poor Index (on the x axis). Index values are for January, conversion of nominal values to real values is done by the January Producer Price Index. The variable shown on the x axis is publicly known at the beginning of each ten year interval. If real stock prices were a random walk, they should be unforecastable, and there should really be no relation here between y and x. There certainly appears to be a distinct negative relation here. The January 1996 value for the ratio shown on the horizontal axis is 29.72, shown on the figure with a vertical line. Looking at the diagram, it is hard to come away without a feeling that the market is quite likely to decline substantially in value over the succeeding ten years; it appears that long run investors should stay out of the market for the next decade.

Is this conclusion right? How can we reconcile it with the widespread public impression that the random walk hypothesis is at least approximately true?

Ratios as Indicators of Market Overpricing

The scatter diagram shown in Figure 1 (and in the subsequent figure) is unusual, in that the measures shown on both axes relate to the long run. Ratios of stock market indices to measures of fundamental value (such as earnings) as indicators of the outlook for the market appear to be most useful when they relate properly to the long run; this is the lesson of a number of recent papers. The denominator of the ratio should be some measure of long-run fundamental value, such as long-run earnings, and the outlook for the market that is to be forecasted should be a long-run one.

John Campbell and I studied the relationship depicted in the figure in a series of papers written in the late 1980s. The R square in a regression of the scatter diagram shown in Figure 1, that is, of the log ratio of prices onto the log price earnings ratio, is 0.514, which means that over this interval from 1901 to 1986, more than half of the variance of the (log) price change could have been explained in advance by this simple ratio. There are some concerns about interpretation of this scatter, due to possible small sample effects, but the strength of the association seems so strong as to suggest that this relation is not consistent with the efficient markets or random walk model.

The ratio used here to predict the stock price changes, the ratio of real price to a thirty-year moving average of real earnings, tends to be higher than the conventional price earnings ratio because earnings tend to grow over thirty years, and so the denominator of the ratio tends to be low. Thus, the average ratio is higher than one might have expected, the average ratio over the sample shown is 18.28.

Meanwhile, taking into consideration the deflationary epoch we're in, even those mid-single digit returns look ample and, as regards SS privatization, they beat the heck out of what the Feds are earning on the "trust funds," no?

Posted by Orrin Judd at January 3, 2005 8:34 AM