Why stocks are 43% too expensive

They’re back: crazy stock prices. Not as crazy as they were 14 years ago, but clearly irrational. A comparison of stocks with earnings tells you that the market is overvalued by 40% to 50%.

The index fund SPDR S&P 500 (SPY) is trading at $184, right where it started the year. Fair value: $129.

What to do? Go to 100% cash? You probably shouldn’t go that far. But you should lighten up your stock allocation, says James Montier, an asset allocation theorist at the Boston money manager Grantham, Mayo, Van Otterloo, a.k.a. GMO. You should definitely lower your expectations. If you were counting on equities to get you to a comfortable retirement, rethink your finances.

GMO didn’t get where it is ($117 billion under management) by making wrong calls, so its projections are worth a look. They are very grim. Large U.S. stocks have an expected real return of minus 1.6% a year over the next seven years, GMO calculates. Invest in small stocks and you can look forward to an annual 5.1% shrinkage in your portfolio’s purchasing power. In U.S. bonds you will find small refuge, with returns barely in positive territory.

Robert Shiller, Yale economics professor and recent Nobel laureate, looks at average earnings for the S&P 500 Index over a full decade, adjusting for inflation so that 2004 can be blended with 2013. The Shiller ratio divides the price of the index by the earnings number. The ratio is hovering around 25, or 49% above its historical average.

That doesn’t mean a crash is imminentcrashes never come on schedule. It just means that, over the next decade or so, stocks are highly likely to disappoint. They might spurt ahead and then crash, or crash and then partly recover or just drift slowly down. Montier isn’t trying to predict the market’s path, only where it is likely to end up.

There’s a counterargument to be made to the GMO thesis, so let’s listen to it. It comes from Jeremy Siegel, a professor at Wharton who is as reliably bullish as Shiller is bearish. They both have victories to claim as market seers. Siegel’s stock market cheerleading in the book Stocks for the Long Run appeared in 1994, a good time to be going long. Shiller published his textbook for bears, Irrational Exuberance, at almost the precise point in 2000 when a great crash was about to start.

Who was right? For five years, Siegel. This debate coincided, it turned out later, with the bottom of the tech-led crash. Then came the financial crisis, and Shiller was vindicated.

Source: Forbes by William Baldwin

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