The Bull Case for U.S. Stocks

Oh, Sunny Day!
Jeremy Siegel put in a good word for U.S. stocks in yesterday's Financial Times.

Some might respond that the sun also rose this morning. The author of Stocks for the Long Run is not known for his bearishness. However, Professor Siegel is quite different from the cheerleading Wall Street strategists who came and went. (Are there even Wall Street strategists any more?) He never tried to predict short-term market movements, nor did he recommend industry sectors. Rather, he offered longer-term advice. And unlike his Wall Street competitors, Siegel was largely correct.

In 1994, in the first publication of his book, Siegel wrote that he expected stocks to beat inflation by 5 to 7 percentage points per year. Spot on. Over the trailing 20 years (through July 2013), the Wilshire 5000 has gained 6.6% per year in real terms. A few years later, as the Great Bull Market emboldened investors, Siegel ratcheted down his long-term expectations, stating that he expected real stock returns to be closer to 5% than to 7%. He didn't get that one right (at least not yet), as the true figure from the market peak has been about 2.5%. On the other hand, he was the most cautious of the stock bulls at the correct time for caution. Half credit there.

A decade later, Siegel had his best moment. In an opinion piece for The Wall Street Journal in February 2009 entitled "The S&P Gets Its Earnings Wrong," Siegel argued that the conventional version of the stock market's price/earnings ratio, as conducted by Standard and Poor's, was unhelpful. American businesses at that time consisted of two distinct segments: 1) highly troubled financial services companies that were posting huge losses and 2) mostly healthy nonfinancial firms that had positive earnings. Putting all of those companies into the same calculation bucket, so that the losses from segment No. 1 eroded the gains from segment No. 2, resulted in a market P/E ratio that was substantially higher than the ratio of the companies in segment No. 2. Stocks looked expensive on the surface--but not if you understood the details.

It was a simple but profound argument that had largely escaped other observers. And it was indisputably correct. Siegel's article proved to be a better guide for stock investors than did the oft-cited signal of the cyclically adjusted price/earnings ratio. Also known as the Shiller ratio, that calculation flashed a neutral signal in early 2009, indicating that the market was fairly priced by historical standards.

Today, Siegel again disagrees with the signal of the Shiller ratio. Again, his quarrel is with the underlying data. Siegel points out that the Shiller ratio has been almost unrelievedly bearish for the past 22 years, being clearly positive for only nine months of those 22 years. Siegel suggests that the Shiller ratio might not be so much early--as claimed by its adherents--as it is wrong. The problem, he writes, is that changes in accounting standards in the 1990s (on write-off policies) distort historical comparisons. This means that today's earnings cannot reliably be compared with earnings pre-2000. In essence, Siegel says, the Shiller ratio no longer can rely on decades' worth of data. It is only about 15 years old.

Another simple argument, as in 2009. Is this one also profound? In that, I am unsure. I felt immediately the power of the 2009 claim, as at the time I was responsible for Morningstar's calculation of mutual fund portfolio ratios, which meant that I was fully aware of the distortions that occur in the figure when companies that lose money are combined with those that make money. (Indeed, for that reason, Morningstar's portfolio P/E ratio is calculated in a different fashion than is S&P's.) I have less knowledge about how write-off policies have changed and thus less conviction in the argument. 

However, Siegel certainly deserves a hearing, based on his past work. He also offers support for his claim. He compares S&P's earnings calculations with the aftertax profit series published in the National Income and Product Accounts, stating that the two figures moved in tandem until about 2000, but now diverge. He also tackles the bearish argument that corporate earnings have nowhere to go but down because profit ratios are currently at record highs. In this case, he has not an alternate data set, but rather a theory, which is that high-margin foreign profits, high-market technology companies, and high margins from fat balance sheets make today's companies different than those in the past.

So, I am inclined to believe. 

In which case the question becomes: If Siegel is correct that the Shiller ratio has entered a new era, what does that signal now show? That is, how do market valuations look within the 13-year context of 2000-12?

Not bad, not bad.

 Source: http://www.econ.yale.edu/~shiller/data.htm

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.