One of the most remarkable features of the recent stock market rally has been its inability to change opinions.
Bulls use the recent advance in global markets to argue that more good times lie ahead. Bears, meanwhile, are equally adamant that the run-up is nothing but a frothy aberration, doomed to end badly.
Both can put some strong arguments on the table – and investors should be familiar with both sides of the debate before deciding whether to put more money into the market.
Bulls, for instance, point out that in a world where fixed income securities yield next to nothing, the dividend yield from stocks is hard to beat. Both the Canadian and the U.S. market are paying more than 2 per cent a year in dividends, which beats the return from GICs and many bonds.
“Stocks are the only asset you can buy where you can get yield,” said Jeremy Siegel, author of Stocks for the Long Run and a finance professor at the University of Pennsylvania’s Wharton business school. “There’s not much else.”
He says the S&P 500 index has a “very good chance” of achieving 20-per-cent growth this year as fears of another financial meltdown subside, and low interest rates in most developed nations provide powerful support for corporate profits.
“I think we’re going to see a fading of the idea that there’s a crisis on every corner,” Prof. Siegel said.
One of the most commonly used stock market metrics is the price-to-earnings (P/E) ratio, which measures a stock’s price against earnings per share.
The S&P 500 index’s current P/E ratio is about 15, according to Bloomberg. That is pretty much in line with historical averages. If corporate earnings go up – and bulls like Prof. Siegel believe they will this year – then the stock market should climb even higher.
A common method of assessing the true health of a market is by comparing its P/E ratio to an “equilibrium” P/E ratio, an estimate of what the market’s true valuation should be. Investing icon Peter Lynch calculated this with what he called the “Rule of 20” – simply subtracting the current inflation rate from 20 to arrive at the market’s equilibrium P/E ratio.
With the U.S. inflation rate currently sitting at 1.7 per cent, the S&P 500 should be trading at 18.3 times earnings, according to Mr. Lynch’s rule of thumb, meaning that there is plenty of opportunity for stocks prices to rise and generate returns for investors.
But other observers beg to differ.
Yale professor Robert Shiller argues that the best way to evaluate the market’s relative cheapness is by looking at its current price in comparison to its inflation-adjusted average annual earnings over the previous decade. This cyclically adjusted P/E strips out the effects of the business cycle.
According to Prof. Shiller, the historical average value of the cyclically adjusted P/E ratio is 16.5. It is now around 22.8, indicating the market is overvalued by nearly 40 per cent.
Other bears argue that corporate profits are doomed to fall, simply because they are running so much higher than historical averages. Credit Suisse estimated in a paper last year that profit margins for non-financial companies in the S&P 500 are at their highest level in more than 30 years.
Ordinary investors may understandably be confused by the conflicting cases put forward by bulls and bears. Many experts say the important thing is to stick to a well-thought-out strategy for allocating your assets and avoid making drastic moves to time the market.
“The amount of market exposure you have should be based, really, on your financial circumstances, and not on market outlook,” said Eric Kirzner, a finance professor at the Rotman School of Management in Toronto.
Investors should instead look at how much risk is right for them, and fit stocks in their portfolio accordingly. Pension plans, for instance, typically keep 60 per cent of their assets in stocks and 40 per cent in bonds.
“In general, investors should be spending 99 per cent of their time making sure their assets are in the right place for them,” Prof. Kirzner said.