It's easy – maybe too easy – to mount a damning case against today's stock market.
Valuations stand at lofty heights and, judging by the lifespan of past rallies, this six-year-old bull run looks positively geriatric.
But despite all the naysaying, it may not be time to bolt out of stocks just yet. Many analysts – and not just the usual perma-bulls – say that today's tired old bull market appears quite capable of trudging even higher.
One important reason for optimism is that stock prices are still cheap in comparison with bond prices, according to John Higgins of Capital Economics. He argues that stocks are likely to continue to be a relative bargain even if the U.S. Federal Reserve begins to raise interest rates later this year.
To illustrate his point, Mr. Higgins offers up an intriguing chart that compares the yield on 10-year Treasury bonds to the earnings yield on the S&P 500 index of U.S. stocks.
A bit of explanation: The earnings yield for the S&P 500 is the total earnings of all companies in the index divided by the combined price of all S&P 500 shares. Think of it as a gauge of how much each dollar invested in stocks generates in terms of corporate earnings.
Mr. Higgins has enhanced the simple earnings yield by averaging the past 10 years' profits and adjusting for inflation. The result is the "cyclically adjusted earnings yield," which should, in theory, reflect the sustainable profits that the S&P 500 can produce over the course of an entire business cycle.
This earnings yield yardstick has often languished well below the 10-year bond yield. Over the past couple of decades, investors have typically been willing to accept a lower earnings yield on stocks than on bonds, probably because of stocks' growth potential.
But not so today. The S&P 500 earnings yield is significantly higher than the yield on safe bonds. Translation: Investors are being well compensated for holding stocks. Even a moderate rise in interest rates wouldn't change the picture much.
Barring an unforeseen crisis or unexpectedly aggressive rate hikes, "we continue to think that the stock market is likely to weather the onset of Fed tightening quite well," Mr. Higgins writes.
This isn't a unique opinion. Aswath Damodaran, a professor of finance at New York University, likes to gauge the market by keeping tabs on the so-called equity risk premium, which he says is "the one number that best sums up investors' hopes, fears and expectations."
In more precise terms, the equity-risk premium is the expected extra return that investors demand over and above what they could get on safe government bonds before they will agree to buy stocks. Prof. Damodaran's estimate of the premium at the start of June was 5.74 per cent, far higher than the norm of 4.07 per cent during the past half century.
The size of the premium indicates that investors are demanding a thick cushion of extra return to buffer them against the inevitable rise in interest rates that may start as soon as this year. The generous risk premium doesn't quite amount to an all-clear signal for the stock market because there's always the risk of unexpected calamity, but it does suggest that today's stock prices are quite reasonable if interest rates rise as slowly as the market expects.
What's surprising about this short-term optimism is that many long-term forecasts for stock returns are downright gloomy. Two money managers known for their quantitative chops, GMO of Boston and Research Affiliates of Newport Beach, Calif., both see U.S. stocks as a disaster area over the next seven to 10 years.
So why the short-term bullishness? It's all a matter of relative value. GMO and Research Affiliates both predict even more pain for bonds than for stocks.
Research Affiliates, for instance, says 10-year U.S. Treasury bonds are likely to produce essentially zero return over the next decade, after accounting for the impact of inflation. In contrast, the S&P 500 will generate an annual real return of 0.7 per cent. So both asset classes will stink, but stocks will stink slightly less.
If there's one thing that investors can do in this unappealing environment, it's to look beyond North America.
Research Affiliates says that European and Asian stocks can produce real returns of 4.1 per cent a year over the decade to come, while emerging-market equities will do better still, generating 7.2-per-cent returns.
GMO also thinks that the best returns will come in foreign and emerging stock markets, although its forecasts for the next seven years are considerably more restrained than those of Research Affiliates.
Market forecasts are notoriously treacherous, of course, but the overall direction seems clear: According to these thinkers, investors should still embrace stocks for the long run – but they should begin looking beyond the North American stocks that have done so well in recent years.