Are Stocks Cheap Yet?

November 18, 2008
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Yes, but they are supposed to be if you want reasonable returns for the risk, which is one more reason the Fed Model is wrong. Compared to the past however not that cheap. Jim Hamilton takes a look:

We’re currently at a P/E around 14, a bit below the historical long-run average P/E of 16.3, meaning you could expect a slightly above-average return from buying stocks now. Specifically, if companies were to pay their shareholders all the income to which they’re entitled in the form of a dividend, that dividend would give you better than a 7% immediate return, and over the long run, the dividend would grow at least at the rate of inflation. That’s a return that proved more than sufficient compensation to investors for the extra risk they faced from stocks over the last century and a half, which included plenty of times tougher than those we’re going through at the moment. To me, a 7% real yield sounds like an attractive investment, despite the risk, and certainly dominates most other alternatives as a long-run vehicle for saving for retirement.

I agree with that, though I think most people would be surprised that attractive pricing means only a 7% yield plus inflation. In fact, dividends are actually likely to grow only 1-2% faster than inflation. Unfortunately we do not get all of that real yield because companies retain far more of their real dividend than necessary and do not distribute it to their shareholders. Much of that retained dividend is wasted. which brings me to a point of disagreement:

But isn’t it possible that the P/E will decline further, to much below the historical average, before the carnage is finished? Sure it is. But here’s another way to look at that. Companies in fact don’t turn over 100% of their profits to the shareholders as dividends, but re-invest some of those profits in the hope that future earnings will increase faster than inflation. The typical stock in the S&P 500 today is giving you a 3% dividend, which you could hope will grow 3% faster than inflation over the long run as a consequence of the reinvested profits. That again to me sounds like a very nice investment. You can buy and hold for the long term with the philosophy that it’s that stream of growing dividends that you really want and are going to get. Let the market price of the stock go up or down from here wherever the psychology of the market may take it– you’ve still received what you paid for, and it’s a reasonable deal.

Loner term those reinvested profits grow only a bit faster than inflation and trail GDP growth. Long term it is only about 1-2% above inflation. So, 3% plus 1-2% plus inflation gives us 4-5% above inflation. Still reasonable, but hardly spectacular. Of course payouts could rise and increase the dividend yield without reducing growth. So 4% dividend yield, plus 2% (let’s be optimistic) and 3% inflation. That is 9%. With some appreciation in the P/E ratio returns could be higher, perhaps substantially so.

The rest of the post is pretty good for someone who wants to invest themselves, needless to say we believe we can, and have, do much better. Not because of stock picking prowess, but asset allocation decisions, especially hedging against risk or avoiding it in many situations. The graph above over the past few years shows why that can be pretty effective. Nevertheless, sound advice.

John Hussman gives a very good way to look at the opportunities and risks in the current market as well, and some sound advice about approaching this with a long term focus but careful attention to the risks. Investing now does offer good long term returns, but you may be able to do better later. Some exposure is certainly warranted and John gives a good explanation as to why. Known by many inaccurately as a “Perma Bear” he is certainly no mindless cheerleader.

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