The significant lack of consensus outlook for U.S. stock markets comes largely from the direction at which differing parties view the market. Those looking forward, basing market valuation on estimated future company earnings believe that markets could be 25+% undervalued.
Those who prefer to use trailing actual figures to evaluate current stock prices, believe nearly the opposite, that the recovery rally went too far and will correct more than the 16% dip in the S&P 500 between April 23 and July 2.
The Bullish View
Jeremy Siegel is a professor and author whose viewpoint is widely followed. He has tracked stock market performance back over 200 years. He believes in reversion to the mean – over time, no matter whether markets race ahead of fair value to overly correct below it, they will self correct and return to long-term mean returns.
In a July 8 interview, he said: “When I draw that line over 200+ years of return data, I find we are about 25% to 30% under trend. But trend lines are only one aspect of it. There has got to be a valuation behind that. That is very much what supports the position that stocks are undervalued. When I look at earnings going forward on the S&P 500, for instance projections for 2010 and 2011, we are looking at either 13-times earnings this year or 11-times next year’s earnings. In this interest rate environment, that is unprecedented and, again, demonstrates around a 25% or 30% undervaluation in the market.”
Siegel goes on to explain that even if he takes a pessimistic view of future earnings that current prices remain undervalued, just not to the same extent.
Jeremy Grantham, a money manager historically bearish in his outlook, leaves open the possibility for stocks to rally strongly. “Despite growing nervousness and a slowing economy, there is still a 45 percent chance, thanks to low interest rates, that the S&P 500 will rise above 1,400 (1,083 on July 21, 29% increase to reach 1,400) by October of next year, accompanied by a speculative spin. High-quality stocks have been cheap for five years, and may spend most of the next several years underpriced, bouncing back up to fair value from time to time.”
The Bearish View
Other analysts and economically-focused investment managers are more pessimistic given the mix of a rear view of real company earnings in tandem with fairly dreadful economic expectations.
Economist and mutual fund manager John Hussman hasn’t found a reason for a promising outlook.
“I continue to urge investors to have wide skepticism for valuation metrics built on forward operating earnings and other measures that implicitly require U.S. profit margins to sustain levels about 50% above their historical norms indefinitely,” Hussman wrote July 19. “I can’t emphasize enough that when you hear an analyst say ‘stocks are cheap based on forward operating earnings’ it would be best to replace that phrase in your head with ‘stocks are cheap based on Wall Street’s extrapolative estimates of a misleading number.’ ”
While Hussman thinks that expectations for 25% U.S. stock market gains are misguided, he does not predict extended negative returns. His forecast in the second quarter outlined a scenario where U.S. markets could log 7% average annual returns over the short-to-intermediate term. While that would be a third lower than long-term market returns, 7% annually will still build wealth, especially in a period where inflation is tame.
Others do leave open significant likelihood of negative returns from U.S., and likely European, stocks.
Yale economist Robert Shiller uses a backward-looking calculation of 10-year average actual net earnings and concludes that U.S. stocks are substantially overvalued.
Everyone is right at some point
For another perspective, consider this graph from Morningstar. It charts collective over or undervaluation of the 1,700 stocks that Morningstar rates. This view is of the past year, suggesting a lightly undervalued market in general. It’s important to remember that individual stocks can get wildly undervalued or overvalued with no relation to the overall market.
What do we think?
The tug-o-war between forward-looking optimists and backward-looking pessimists is at a point where each side maintains a lot of strength. It could be that both sides are right. We may see a lot of up and down moves without a clear winner from either viewpoint.
One may be right in the short term but the other over a more meaningful longer term.
We favor evidence over expectations. That leads us to believe that the U.S. stock market is unlikely to add 25% or 30% to its value in the next year. Multi-national companies able to pay increasing dividends and established emerging markets companies appear most attractive. U.S. Treasuries are least attractive.
While we accommodate for occasional tilts in emphasis within our clients’ portfolios, we still operate from a core asset allocation that is globally diversified. This is the best way to remain aligned with client goals that will endure beyond the uncertainty of today.
– Gary Brooks, CFP®
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