Two years ago, as the stock market staggered toward bottom and the global financial system teetered on the brink, many investors sobbed that they would never again buy anything more adventurous than a GIC. These days, after watching world markets double from their 2009 lows, a lot of those same people are once again gobbling up stocks. Despite the Japanese earthquake, Middle East turmoil and monumental global imbalances, equity prices keep steaming ahead.
The mood swing has been extreme even by Mr. Market's notoriously fickle standards. And it raises an obvious question: Will today's ebullience prove to be any more realistic than the despair of 2009?
One of Canada's most successful investors is not at all convinced by the current bullishness. In his annual letter to shareholders, Prem Watsa says his company's stock market portfolio has been 100-per-cent hedged against the possibility of decline since early last summer. The chairman of Fairfax Financial Holdings cites a host of worries: a housing bubble in China, austerity in Europe, and the effects of too much debt in the financial system.
He's not alone in his concerns. GMO, the Boston-based money manager, has predicted the trajectory of the stock market's dive and recovery as well as anyone over the past few years. It is now forecasting that U.S. large-cap stocks will produce next to no real return over the next seven years, while small caps are likely to actually lose ground. If its prognostication comes true, investors in most U.S. stocks face years of frustration ahead.
Many people, of course, will take issue with that glum forecast. But the bears' doubts are based on a good grasp of history.
The most robust way to value the stock market is to ignore annual earnings, which can be volatile. Instead, investors should compare current stock prices to average real earnings over the full cycle of the past 10 years. This approach, developed by Yale professor Robert Shiller, places stock prices in the context of their long-run earnings power.
Right now, the Shiller P/E for the U.S. market stands at a lofty 24, well above its long-run average of 16. The good news is that the ratio is still far below its peak of nearly 50 during the insanity of the dot-com bubble. Unfortunately, the current value is in line with major market tops in 1966 and 1901. At the very least, it indicates this market is expensive and likely to produce disappointing returns in years to come.
Of course, that's thinking long term. The immediate problem for investors is that valuation is a lousy guide to where the market is headed over the short term. Expensive markets can get even more expensive (think the 1990s). Cheap markets can get even cheaper (witness the 1970s).
So where should investors head in these frothy but uncertain times? Value stocks seem like an obvious refuge, but James Montier, a GMO strategist, warns investors may have a tough time finding them. He recently went looking for stocks that could meet deep-value criteria resembling those laid down by the fabled Benjamin Graham, and found that they have all but vanished in the United States and Europe over the past two and a half years. Bargains are more common in Asia but even there the number of deep value stocks has been dwindling rapidly.
Another approach is to tilt your holdings toward what GMO calls "high quality U.S. stocks" - those that have steady profits, low leverage and high returns on equity. The money manager predicts these stocks, which include such stalwarts as Oracle Corp., Microsoft Corp., Johnson & Johnson and Pfizer Inc., will produce annual real returns of 4.5 per cent a year over the next seven years.
Emerging market stocks are also attractive - at least, relatively speaking. GMO figures they, too, will produce 4.5-per-cent real returns over the next few years. That is far below most investors' expectations, but it looks positively generous in comparison to the minuscule gains that GMO expects from most stocks and bonds. To Mr. Montier the lesson is clear: "The absence of attractively priced assets with good margins of safety should lead investors to raise cash."
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Bob McWhirter, president and portfolio manager of Selective Asset Management Inc., will take your questions on the outlook for the tech sector, and which stocks may be best poised to outperform, during this live one-hour discussion at 12 noon ET March 17.
Mr. McWhirter has more than 30 years in the securities industry and is a top-ranked money manager in Canada. He manages Selective Asset Long-Biased Equity Hedge Fund using a 12-factor stock selection methodology that has both growth and value characteristics. Prior to establishing SAMI, Mr. McWhirter was vice-president and portfolio manager at First Asset Investment Management Inc. and RBC Global Investment Management Inc., where he worked for more than 20 years. During this period, Mr. McWhirter managed approximately $2.25-billion in the Canadian High-Technology sector of the Royal Bank's Canadian Equity Mutual Funds.
Readers using mobile phones should read the discussion by following this link.
Ian McGugan