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Rekenthaler Report

Burton Malkiel's Latest Advice for Investors

Patience, emerging-markets stocks, and municipal bonds.

Bait and Switch
In yesterday's Wall Street Journal, Burton Malkiel asked, "Are Stock Prices Headed for a Fall?" Surely a tease, I thought. This past December, in the same space no less, Malkiel wrote that "nobody can foretell what the market can do in 2014." Has he had a revelation? Has he realized that he is The One?, he doesn't. The article completely avoids the question.

It does, however, discuss three other items.

All Things Considered...
While Malkiel won't touch the stock market's immediate future, he does speculate about its long-term prospects. Like many, he is wary. The cyclically adjusted price/earnings ratio, or CAPE ratio, is 25, well above its average level of 15. Malkiel writes that while the "CAPE is not useful in predicting returns one or two years into the future"--what indicator is?--that it "does a reasonably good job of predicting 10-year equity returns."

Of that I am not certain. To my mind, London Business School professors Dimson, Marsh, and Staunton have convincingly demonstrated that the CAPE ratio has been predictive after the fact, but not beforehand. When the trio simulated what the ratio would signal using only information that was available at the time, they found that the forecast had little power.

In addition, Wharton professor Jeremy Siegel argues that accounting changes pose problems when comparing today's CAPE ratios with those of the past. Earnings, of course, are created by accounting; as accounting standards change over time, so do the earnings they govern. It's also quite possible that stocks today are less risky than they were 50 or 100 years ago--actually, it's quite likely--which would also support a higher ratio.

Also, even if the CAPE ratio is robust, it's difficult to put such a market-timing indicator to use. Was Alan Greenspan correct when he suggested that the U.S. stock market was "irrationally exuberant" in 1996? He did so in part after Robert Shiller discussed the CAPE ratio with him--and he was in part correct in that assessment, given the fierce 2000-02 downturn. On the other hand, as Malkiel mentions, there was a lot of money to be made for the next four years (and decent money over the full 10-year period). Thus, Greenspan's statement didn't offer much help to investment portfolios.

Malkiel's argument for holding fast is different. He points to low interest rates supporting high stock prices as a counterbalance to the unpleasantly steep CAPE ratios. This leads him to take the middle ground. "Long-run equity returns from today's price levels are likely to be considerably lower that their 10% long-term average." Which is fine, if Treasuries continue to pay 2%-3%. Stocks can make 7% and still deliver a healthy, albeit lower than normal, equity premium.

Ultimately, then, the headline was a head fake; the article offers the standard advice of staying the course. Then again, this summer's Morningstar Investment Conference featured a similar conclusion from the asset-allocation panel. Like Malkiel, the panelists were bothered by stock valuations but felt that low interest rates (barely) compensated. That does seem to be today's investment consensus. Let's hope that it's not solely rationalization.

One Step Forward, Two Steps Behind
With stocks, Malkiel highlights emerging markets. "All equity portfolios should include the emerging markets," he writes. This, too, echoes the advice of others. The emerging-markets sector, of all sectors, is most frequently singled out as a place investors should not miss.

This, too, gives me pause. There was a time when I also believed, as Malkiel writes, that because emerging markets "are growing far more rapidly than the developed markets" and "have less government indebtedness and much younger populations," they were destined for higher total returns. But my views have changed.

What emerging-markets companies give with higher growth rates, they take away with shareholder-unfriendly policies. For that reason, the emerging markets perpetually have a much larger share of global gross domestic product, or for that matter global trade, than they have of the world's stock-market capitalization. Their companies generate high revenues, create business opportunities for partners, greatly enrich corporate managements, and reward government officials. But they don't do much for common shareholders. Their stock prices, appropriately, reflect that fact.

(For all the attention paid to China's spectacular, record-breaking growth rate, the country's equities have been spectacular laggards. Over the past 20 years, China stocks in aggregate have done nothing. Investors would have been far better off owning an index of dull, blue-haired countries.)

That said, today's emerging-markets valuations are as relatively low as any in recent memory. As Malkiel points out, while U.S. stock CAPE ratios are well above their long-term average, emerging-markets CAPE ratios are sagging. Cyclically adjusted P/E multiples for emerging-markets stocks are not only well below U.S. levels but also below their own norms for the past two decades. Thus, emerging-markets stocks look to be cheap twice over.

Here, too, several Morningstar Investment Conference speakers echoed Malkiel. For example, the money-management firm GMO currently rates emerging-markets stocks as the asset class with the highest expected return over the next seven years. Could the smart money be wrong? Yes, it could, but the bet looks sound. The emerging markets might not be an evergreen selection, as Malkiel suggests, but their prices seem right for today.

For Specialized Tastes
Malkiel concludes by recommending municipal bonds over taxable bonds (for taxable accounts, of course). As with emerging-markets stocks, munis tend to trade at lower levels than a pricing model might suggest. Once again, there's good reason for the pricing discrepancy. Whereas emerging-markets stocks are handicapped by crony capitalism, muni bonds are hurt by poor disclosure and low liquidity. They should have better aftertax yields than taxable bonds, because they're not as good as taxable bonds.

However, as Malkiel states, the discounting process may have gone a bit too far. He cites leveraged closed-end muni funds that now yield in excess of 6%, more than double the payout of Treasuries. That's quite a premium to be in munis. Then again, these funds assume a lot of interest-rate risk. They're definitely not an investment for everybody--perhaps not for anybody, if one believes that rates will soon rise. The emerging-markets stock opportunity, for me, is the stronger of the two options.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for 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.