stocks strategies for a challenging decade ahead

8/13/2019 Stocks Strategies for a Challenging Decade Ahead

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Stocks: Strategies For A Challenging Decade Ahead

Stocks: Strategies For A Challenging Decade Ahead [SPDR Gold Trust (ETF), iShares Silver Tru... http://seekingalpha.com/article/1671472-stocks-strategies-for-a-challenging-decade-ahead

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earnings was catching up with the price. This level represented a 15% discount to the long-term historical average of 16.0x over the last century.But in the two years since late 2011, stock prices have risen aggressively while earnings growth has effectively stalled. This has resulted in stocksrising purely on multiple expansion and a 12-month trailing P/E ratio that is now at a 12% premium to its historical average at 18.0x. This is high,

but not egregious.

(click to enlarge)

While valuation based on trailing earnings is more reliable than forward earnings, it is also problematic as a valuation tool for the following reason.Certainly, the advantage of trailing earnings over forward is that it is based on events that have already happened, which obviously reduces theuncertainty in the underlying data tied to this approach. However, if you are investing with a long-term horizon lasting over a decade or more,concentrating only on what has taken place over the past year is far too narrowly focused. This is due to the fact that earnings results any givenyear are influenced heavily by where we currently are in the economic cycle. For while earnings may be depressed when the economy is troughingduring a recession, they are also likely to be inflated when the economy is peaking during an expansion. Thus, investors attempting to extrapolateearnings data forward based only on recent earnings data run the risk of outcomes that are vastly different than expectations as the economy shiftsalong the business cycle. And the risk is particularly high for a disappointing outcome when applying this approach in the fifth year of a virtuallyuninterrupted stock bull market supported by unprecedentedly aggressive monetary policy.

Take 3: 10-Year Cyclically Adjusted P/E Ratio ( CAPE )


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Those that contend that stocks are overvalued are often focused on the cyclically adjusted price-to-earnings ratio over the past ten years. Based onthis measure, any attractive valuations for stocks were fleeting at the very depths of the crisis in late 2008 and early 2009. For example, the CAPEon the S&P 500 Index edged below its historical average of 16.4x over the last century for a mere seven months from November 2008 to May2009. And after this brief valuation dip, stocks quickly returned to being vastly overpriced. Today, the CAPE on the S&P 500 stands at 23.0x,which represents a 40% premium to the long-term historical average of 16.4x over the last century.

(click to enlarge)

The 10-Year Cyclically Adjusted P/E Ratio is an advantageous stock valuation metric for several reasons. While it is certainly not a very usefultool for those focused on short-term trading, it is a far more relevant measure for the many market participants that are investing with a long-termtime horizon. This is due to the fact that it is a reading that is based on actual historical numbers and also covers a sufficiently long time period thatstretches across full business cycles. Thus, it provides a more reasonable measure of what long-term investors should expect over the coming years.

The ability of the CAPE to predict future stock returns also makes it an important measure for long-term investors. Although the CAPE at anygiven point in time is derived using ten years worth of historical earnings, it has demonstrated an extremely high inverse correlation in predictingannualized stock market returns ten years forward. In other words, the lower the CAPE is today, the higher the returns for stocks over the followingten years. And the higher the CAPE is today, the lower the returns for stocks over the following ten years.

The chart below demonstrates the strength of this relationship. The blue line is the rolling 10-year annualized return on the S&P 500 Index over the


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past century with the data shown on the right axis. The orange line is the 10-Year CAPE shown on a rolling monthly basis over time with the datashown on the left axis. For the purposes of this analysis the CAPE chart has been inverted and is shown with a ten-year lag. In other words, a data

point for any given date is showing what the CAPE reading was ten years before that date.

(click to enlarge)

A CAPE reading at any given point in time has historically provided the strong ability to predict annualized stock market returns over thesubsequent ten years. This has been particularly true from the Great Depression up until just before the turn of the new millennium with nearly aone-to-one relationship between the two. Some deviations did exist at the early part of the last century, but this was a time from the 1900s to the1920s where stocks trailed the potential suggested by their valuation during an environment marked by greater economic volatility, a near marketcollapse in 1907, the creation of the U.S. Federal Reserve in 1913, World War I in the mid 1910s and a major depression in the early 1920s. Butonce the Great Depression arrived the relationship has been tightly correlated ever since. That is, of course, until recent years where stocks havevastly exceeded their potential as suggested by the CAPE.

So what exactly changed a few decades ago that suddenly caused long-term stock performance to exceed their valuation potential implied by theCAPE? It was most likely the advent of monetary policy designed to eliminate recessions from the business cycle starting in 1986 and the"Greenspan put" that came the following year in 1987. These two policy strategies alone created a climate where investors were willing to payhigher prices for each dollar of earnings over long-term periods of time bolstered by the confidence that they were exposed to on less risk to thedownside thanks to the Fed, which helped to push prices higher. Thus, starting in 1996, which marked a full ten years of these supportive monetary


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focus elsewhere. This, of course, is what China ( FXI) has been doing over the last few years in working to carry out long-term reforms in anattempt fix the underlying structural problems in their economy, and we see how their stock market has performed along the way. And what if theFed actually came to the conclusion that allowing a recession to occur (gasp) is actually a good thing for an economy in that it periodically allowssome of the pent up excesses to be cleansed from the system and strengthens the economy for the next growth phase. To emphasize, I'm notsuggesting that policy makers should allow the economy to collapse, but to simply let it go into recession every few years consistent with its naturalcycle over time. What would such a change in policy imply for the U.S. stock market based on the CAPE model?

First, stocks would likely undergo a prolonged corrective phase as the artificially inflating effects of supportive monetary policy on stock prices isunwound. For example, the S&P 500 Index closed on Tuesday at 1639. But if one were to project what the stock market should be trading basedon the CAPE model without the support of monetary policy and with all else held equal, the S&P 500 would likely land in the 975 to 1025 rangetoday. This implies that today's stock market is anywhere from +35% to +45% above where it should be trading in a normal environment thanks tothe artificially inflating influences of the Federal Reserve. While trading at such lower levels may seem like an outlandish notion given where theS&P 500 is today, it is worth recalling that stocks were trading at or below this range as recently as three years ago.

(click to enlarge)

Second, once this unwind was completed, the subsequent recovery in stocks over the remainder of the decade would likely be muted at best. This isdue to the fact that even with a sharp correction in prices, stocks would still be fairly expensive for some time based on its 10-year CAPE. Thisimplies U.S. stocks need to backfill and consolidate for years of overvaluation relative to underlying earnings, resulting in a market that is

Stocks: Strategies For A Challenging Decade Ahead [SPDR Gold Trust (ETF), iShares Silver Tru... http://seekingalpha.com/article/1671472 stocks strategies for a challenging decade ahead

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If we do indeed enter a prolonged challenging period for investment markets, holding a significant portfolio allocation to cash at any given point intime may be considered ideal. This is due to the fact that a near 0% rate of return is a far better outcome than a -30% decline or more in portfoliovalue. In addition, those standing at the ready with cash are best positioned to pounce once extraordinary investment opportunities presentthemselves. One has to look no further than Warren Buffett to see how holding a meaningful allocation to cash can work so well over time.

Investment markets may be facing a challenging road ahead in the coming decade. But with challenge comes opportunity. And those investors thatare aware of the risks ahead and stand ready to capitalize have the potential to realize outsized rewards in the years ahead even if the broader U.S.stock market finds itself stuck in the mud.

Disclaimer : This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections madeby GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

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Stocks: Strategies For A Challenging Decade Ahead by Eric Parnell

About this articleEmailed to: 305,839 people who get Macro View daily.Author payment: $0.01 per page view, with minimum guarantee of $500 for Alpha-Rich ideas plus free access to Seeking Alpha Pro.Become a contributor Tagged: Macro View , Market Outlook , CFA charter-holdersProblem with this article? Please tell us. Disagree with this article? Submit your own .

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Comments (42)

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bbro Comments (8318)

Shiller PE has been above 19.5 since November 1 ,2009 ...the SPY isup 71.47% (dividends reinvested) since November 1,2009.....

the Shiller PE was above 23 during the period from 3/01/03 to 10/01/07...SPY was up 81.88% ( dividends reinvested) for that period....as you can see the Shiller PE misses some big up moves....

There are better indicators when to exit a bull market....

P.S. Remember the CAPE 10 has got a 13.51 annual earnings for 2008 included in its 10 year calculation....4 Sep, 03:13 AMReplyLike7

6151621 Comments (415) I hope your cash holding isn't INR.4 Sep, 04:22 AMReplyLike1

Amouna Comments (1107) Great article Eric!

One concern I still have is the high correlation between all markets that we have become accustomed to, which means that the next

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corrective phase will take down all assets without discrimination. I personally think it is wise to wait until such event happens while havingcash on hand, then start the allocation process to where one sees fit.4 Sep, 05:15 AMReplyLike10

Eric Parnell Comments (1643)

Hello Amouna,

Thanks for your comment and I agree with you completely on your point about heightened asset class correlations during recent corrections.This is something that I'm hoping to explore in an upcoming article, but I agree that holding a meaningful allocation to cash is the best way tonot only protect but capitalize.

Thanks again.4 Sep, 10:17 PMReplyLike0

samuraitrader Comments (374) I believe that the higher correlations we are seeing, both within asset classes around the planet and across asset classes, is due to thecontinued interconnectedness that is happening thanks in most part to technology. Call it globalization if you like.

I believe this interconnectedness to be a good thing as the only way for the human race to survive the 21st century is to act as one.Interconnectedness means interdependence and those that depend on each other will work together.5 Sep, 07:16 AMReplyLike1

samuraitrader Comments (374) I agree that the rest of this decade will be challenging but for added reasons.

First is the demographic picture. Terrible demographics in Europe, Japan and the Anglo-Saxon countries. Europe and Japan will just continueto get worse economically. China also has poor demographics. The US will fare better in the long run because of its immigration.

Second is the need to deleverage from the orgy of leverage of the last decade.

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4 Sep, 07:05 AMReplyLike8


Hello samuraitrader,

Thanks for your comment and excellent point on the demographic challenges facing the markets in future years, as I believe this is likely to become an increasing headwind over time.

Your point about the need for deleveraging in the financial system. I was thinking about this very topic tonight with a focus on the idea thatthere is now so much underlying tension in the global financial system that we find ourselves at a potential tipping point in what seems likeevery several months with the last episode being the liquidity squeeze in China in late June. This leads to the question of what exactlyhappens when policy makers either don't act in time, are no longer able to act or suddenly find their actions insufficient or ineffective. Therisks for such an outcome seem to be rising with each passing month.

Great points. Thanks again.4 Sep, 10:22 PMReplyLike0

Saltman Comments (32) Excellent article.

Not many writers highlight the ~17 year secular bear/bull cycles and the signal of their completion with respect to a return to a historical lowP/E ratio, but it is clear these cycles exist. With the current secular bear market beginning around 2000, we still have a few years to go beforethe bottom is put in. You rightly mention that investments going forward should include commodities, since they run counter-cyclically to the

broad market cycles.4 Sep, 08:10 AMReplyLike5


Hello Saltman,

Thanks for your comment and I agree with your points. I believe the Fed had the opportunity to facilitate the cleansing process in thesummer of 2010 by forgoing additional stimulus through QE2 and letting the global economy and its financial markets undergo the corrective

process given that they were by then pulled back from the brink. Taking the medicine just as Chairman Volcker did back in the early 1980s

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might have led to the secular bear market ending ahead of schedule. But by opting for more and more stimulus, it is likely to only serve to prolong the secular bear market for years to come now. And the required cleansing process will likely be all the more painful than it couldhave been had it been allowed to take place more than three years ago.

Thanks again for your comment. I appreciate it.4 Sep, 10:27 PMReplyLike0

scchan.2009 Comments (188) I think a key point to see if SP500 PE is overvalued is to compare with current interest rates. With 10-yr Treasuries now moving close to 3%,the spread between 1/PE and the Treasuries yields has narrowed considerably. Many stocks do remain reasonably valued - especially in tech,industrials, and commodities, but I think many traditionally defensive stocks (PG, Coke, Southern, Kroger, etc) are on the expensive sidenow. It isn't just defensive stocks in US, but many defensive stocks overseas are seeing the same problem (even Nestle has upper teens P/E).

So yes, stock selection is a big deal now. I think the reason why many cyclical and sensitive sector remains cheap is investors seem to lack faith in the long term outlook of them. Anyway, most of the time such view is often wrong - IBM, GE and Ford blah blah have survived for such a long time. I would say show some balls to enter a position into them.4 Sep, 08:43 AMReplyLike1

User 13338882 Comment (1) The last 40 years is a mix of extremes in both directions for the econonmy and performance of financial markets. Through it all, stocks havecompounded at about 10%, which is pretty close to what it has done in the last 100 years. Yes, the opportunity is more global but is theability to short the market or stay in cash really the answer to building wealth? The future is challenging, but is that any different than it has

in the past? If you say but now it is different, I suggest you go to the history books.4 Sep, 08:57 AMReplyLike3

ilya716 Comments (8) Just one world for the following decade, the one that is strangely absent in the article - inflation.Cash is still King but will be?4 Sep, 09:14 AMReplyLike1

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samuraitrader Comments (374)

we are in a deflationary cycle right now. that is what the Fed is fighting. and yes, in a deflationary cycle, prices can increase. as the velocityof money slows and bankruptcies occur thru the inability to service debt, the survivors raise prices.4 Sep, 09:25 AMReplyLike2

scchan.2009 Comments (188)

Cash hoarding itself encourages deflation.

It has been that way for Japan for 20 some years - that is QE is an integral part of Abenomics.

A bit of inflation expectations: Up until recently, TIPS had negative yields (it finally turned positive last few months), which means many still believe inflation will pick up. The problem with inflation/deflation expectations is that we have money hoarders on one side, on the oppositeside there are folks hate Helicopter Ben personally about QE. Even Krugman joked "Hating an economist with a beard is not soundinvestment strategy."4 Sep, 09:37 AMReplyLike2

KRV Comments (114) The current CAPE Shiller ratio level is the same as was seen in 1998 and in 2003 and also in 2009. Yet, investors who stayed in the marketfor the following 3-4 years (esp. in 2003 or 2009) since then have been rewarded quite well. Also, note that in all of those yearsaforementioned, the ZIRP and QE did not exist practically as they do in 2012-13 period. Unprecedented liquidity is in the markets these daysand yet the CAPE ratio is at 2003 or 2009 levels. Some can use the same metric and call this undervaluation! While nobody knows what thefuture holds, using the Shiller CAPE metric to determine overvaluation has not served investors in the past. Perhaps there are better

behavioral finance indicators...4 Sep, 09:44 AMReplyLike2

pserini Comment (1)

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DazeYaVoo Comments (11) Just a friendly suggestion: If you want people to read all that you've written, you need to do a double-enter (like two carriage returns on a

typewriter) at the end of paragraphs. It gives more space to your writing and more space for the reader's eye to rest.

Otherwise everything just runs into everything else and makes it look like a long slog to read through. I'd like to read what you've written, butit looks like too much work, so I move on to someone who has put more "white" space in their long posting.4 Sep, 02:28 PMReplyLike4

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stocks strategies for a challenging decade ahead

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