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By Samuel Lee | 11-21-2013 10:00 AM

Lee: Expect Below-Average Stock Returns Ahead

We're far from 2000 P/E levels, but investors should moderate their expectations for high returns and consider reducing their U.S.-equity risk exposure, says Morningstar's Sam Lee.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Does the market look too expensive right now? I'm here with Sam Lee. He is editor of Morningstar ETFInvestor to look at some of his favorite valuation metrics and what he is expecting for returns.

Sam, thanks for joining me.

Sam Lee: Pleasure to be here.

Glaser: Let's talk a little bit about how you think about market valuation generally. What are some of the metrics that you look at to figure out if the market looks expensive or cheap?

Lee: My favorite metric by far is the Shiller P/E, or the Shiller price/earnings ratio. And it's very simple. All it does is it takes the 10-year average of earnings. inflation-adjusted. and divide it by current price. And what this tells you is, what is the market's underlying fundamental earnings power. And it smoothes out the effects of the business cycle; business cycles can range anywhere from five to seven years.

I think it's a very elegant way of measuring it. It's actually not invented by Robert Shiller, the Yale University economist who recently won the Nobel Prize. It was actually first proposed by Benjamin Graham and David Dodd all the way back in the 1930s. This is a very old idea, but it's one that, I think, has stood the test of time.

Glaser: What's the Shiller P/E telling us right now? Where does it stand versus historical averages?

Lee: The Shiller P/E recently hit 25. When you invert that you get is another measure that I like: the cyclically adjusted earnings yield. The inverse of the Shiller P/E, 1 divided by 25 is about 0.04, or 4%. And this is the smooth earnings yield of the market. This is actually, I think, a reasonable forecast for what the market can be expected to return during the next 10, 20 years. And a 4% real expected return is well below the historical average of 6.5%.

The Shiller P/E is saying that the market is overvalued relative to history, that you can expect about 2 percentage points less per year over a long period of time.

Now, whether that's overvalued or undervalued depends on what you believe about the market. People assume that because the Shiller P/E is 25 right now, and the long-term average of Shiller P/E is 16, that the market is way overvalued, 50% overvalued or so. And I don't think that's necessarily the case because the market's valuation also depends on prevailing interest rates.

Right now, interest rates are extremely low, and the bond market expects interest rates to stay low as far as the eye can see. And if you believe this is true, then the market's current valuation is actually quite reasonable because the spread between what you can get in bonds versus what you can get in stocks is still around the historical average, about 4 percentage points.

But if you don't believe that the bond market is right, that interest rates will stay low as far as the eye can see, that interest rates will somehow revert to the mean, then the stock market doesn't look so attractive. This is because when bonds start going up and their interest rates start offering competitive yields with the market, the market has to lower its price to bring its earnings yield up. It's really a question of what do you believe about interest rates. Ultimately, I think the stock market is still implicitly a bet on interest rates.

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