Are stocks cheap? Not quite…but close.

Given the recent plunge in the stock market, are stocks cheap? That is the multi-trillion dollar question.

My base case is that we are part-way through a long term (or "secular") bear market that began in 2000. While inflation has masked a bit of the decline in the overall stock market, it is clear that we put in a generational valuation peak in early 2000 and have been grinding our way lower since. The bear market turned into a "Kondratiev Winter" or economic bear in 2008 with the collapse of the real estate and credit markets. Since that time we have been in a "deleveraging" phase, which would have been deflationary if not for the desperate money-pumping and fiscal stimulus that has occurred since that time. Interest rates have collapsed, yet demand for borrowing is weak as consumers and business focus on improving their balance sheets. Many lack the collateral to borrow even if they wanted to. In addition, the baby boomers are staring at retirement having under-saved. The brutal decline in their net worth and the proximity to retirement are pushing baby boomers toward safer investments like bonds, even while the Fed punishes these savers with super-low rates in a futile attempt to get people to shift back into real estate and stocks.

S&P 500 below trend

In addition, the high inflation of the last 50 years has actually made stocks look like a better investment than they really are. If we convert the value of the S&P to 2010 dollars (as measured by the CPI), we can see that its trend line has only gone up by about 2.5% per year in real terms since 1960.

Source: Standard and Poor's,, calculations by

The good news is that the market is now below its trend line. The bad news is that in bear markets like the 1930s and 1970s (or in bull markets like the early 1960s and 1990s) the market can get very far from its trend line. The good news is that the double-digit deflation of the 1930s and the double-digit inflation of the 1970s are probably special cases. The bad news is that the 1990s bull market and the 2000s credit bubble were also of unprecedented magnitude and ought to be followed by a major bear market to undo the excess. The good news is that the bear market in stocks should bottom before the credit bear market (if that can be called good news).

Valuation based on trend earnings

So what about valuation? To smooth out the business cycle and to adjust for the effect of swings in inflation, I base my market valuation on inflation-adjusted trend earnings. A graph of inflation-adjusted (as-reported) earnings and the calculation of the trend line is shown below.

Source: Standard and Poor's,, calculations by

Expected inflation-adjusted earnings for 2011 are near the peak of 2006. Trend earnings, however, are only $62.15 in mid 2011. If I take the historical dividend payout ratio of 42.8%, the 2.7% long term inflation assumption implied by today's treasury curve and the long term real earnings growth rate of 1.55% as calculated above, I calculate that someone buying the S&P 500 today can expect a long term return of 6.6%.

Of course, the implied return is highly sensitive to inflation. If the inflation assumption fell to 2.25% (near the Fed's long term target), the S&P 500 would need to fall another 100 points just to earn the same return.

The matrix below shows the different levels of the S&P 500 that would generate target returns ranging from 6.0% to 8.0%, assuming long term inflation of 2.7%. Many market prognosticators assume 8% to be the long term return on stocks (wrongly, in my view). I assume the equilibrium return is 6.8%. (I realize that is weirdly precise…there is no exact right answer). To reach an equilibrium return, we "only" need to see the S&P 500 fall another 5%.

The effect of inflation

I am on the record that I believe in the intermediate term, inflation is more likely to surprise the market on the downside than on the upside. The chart below shows the inflation assumptions for the next 5 years, for 5-10 years and for 10-30 years, according to today's nominal and inflation-protected treasury curves. (I also included the actual inflation rates for 2009 and 2010 for illustration).

Source: (for treasury prices), (for historical inflation), calculations by

If we assume that long term inflation expectations fall to 2.25% sometime in the next year or two, we would need to see the market fall to under 1,000 (20% or so lower than today) to be comfortably earning a return of 6.8% or more.

Earnings yield on trend earnings

Another way to look at stock valuations is to look at the market's "earnings yield" using trend earnings (the inverse of the price-to-earnings or "PE" ratio).

Source: Standard and Poors,, calculations by

Looking at the chart above, it appears that we can be reasonably comfortable that we will earn a strong long term return at earnings yields above 6% (a 16.7 PE or below on trend earnings). That would imply an S&P 500 of 1,036 at today's level of trend earnings.


Using the methods above, we can say that the S&P 500 is fairly valued on a long term basis somewhere between 1,075 and 1,000 or so. We are currently at 1,121, so a drop of another 4-8% would put us in a good range. That said, from a trading perspective, the market could punch through to well below those levels if we have a deflation scare (which is certainly possible in this environment). We could also have one more big rally before the big bear market bottom is put in (also highly possible).

Given the monster rally in bonds, my investment strategy will be to average out of my bonds and gold into stocks over the next two years as long as the S&P is below 1,150. (Thankfully, I have been underweight stocks and overweight bonds for a long, long time.)

Good luck out there. These are not easy markets to navigate.

I am not your investment advisor. All opinions in are solely my opinions and are written for my personal enjoyment only. Do not act on any advice given on this site without first consulting your own investment advisor.

The market does not want austerity (now)

If one looks at both nominal and inflation-adjusted treasury yields for the next five years, the market does not think near term austerity is necessary. In fact, it is pretty clear that the market wants more treasury issuance not less, with negative real yields through at least the next five years. With fiscal stimulus being reined in, the market expects the Fed to be the stimulator of last resort (and all the Fed can do is try to promote inflation through bond purchases), hence the gold price is rising as the market expects an even longer period of negative real interest rates.

Our economic problem is simple, we went from a period of over-stimulated and debt-fuelled real estate investment running at 8.5% of GDP to a collapse in real estate investment down to 4% of GDP. The collapse in real estate prices reduced the collateral value on trillions of dollars of loans and forced austerity among consumers.

To deal with the problem we needed only three steps:

  1. Recapitalize the banks to prevent an uncontrolled unwinding of leveraged positions (done);
  2. Increase temporary transfer payments to individuals to prop up consumer spending while savings levels are increased (done, but in danger of being unwound); and
  3. Increased government investment in infrastructure to put the millions of unemployed construction workers to work (not done, we focused on health care instead).

Business investment, exports and consumer spending have been doing fine since we came out of the recession, but the markets are fearing that a pullback in government spending worldwide, combined with continued weakness in real estate investment will tip the scales to recession.

I personally think the odds favor us muddling through for the next year or so and avoiding recession, and that the recent market correction is probably overdone. That does not mean I am calling a bottom, because the momentum could overwhelm the facts on the ground. I do, however, feel ok nibbling at stocks at this level.

With US banks in far better shape than in 2008, I don’t see a mini-replay of that crisis as the major threat to the economy. Europe has major issues, but they are also solvable in due course as long as Germany steps up to the plate. The next crisis may come from exactly where we don’t expect it today: a crash in emerging markets leading to global deflation.


Seeking American Renewal

We are flailing economically. No question about that. Sadly, no one has any good answers for what to do about it.

Sometimes, there's just not that much to do. We just have to ride it out.

The immediate economic problem is quite simple. There is a gigantic hole in the economy where real estate investment used to be. The chart below pretty much sums it up.

Source:, calculations by

As a percent of GDP, business investment has snapped back nicely and has returned to a relatively normal level. As I mentioned in my previous post "Momentum is Building", I think we are likely on the front end of a powerful investment cycle for business investment.

Real estate investment, on the other hand, has cratered to by far the lowest level recorded since World War II.

Enter John Maynard Keynes

The Keynesian economic solution would be for the government to step in and fill the hole in demand (1) by supporting consumption with lower taxes and transfer payments and by (2) directly investing in infrastructure and other public works. The government has done plenty of number (1), which is why our deficit is so large, and not enough of number (2).

What people forget about Keynes was that he advocated withdrawing stimulus and running surpluses when the economy is strong. Instead, the "Keynesians" that have been running our economy since World War II (and that includes both political parties) have made stimulus a permanent feature of our economic policy. Overall it worked great…until 2008.

As a result, we have run up huge debts in all sectors of the economy (government, financial, consumer, business).

Source:, calculations by

And have gotten to the point that government transfer payments and health benefits are equal to about 20% of GDP.

Source:, calculations by

Even more disturbing, if we total transfer payments and investment income (dividends, interest and rental income), non-work income equals 35% of GDP, while work-related income (wages, salaries and proprietor's income) equals only 50% of GDP. This is a classic sign of potential national decline, when more and more income flows to the upper "rentier" class and the government mollifies the masses with transfer payments.

This trend can also be seen as fewer people of working age are even participating in the labor force (working or looking for work).

Source:, calculations by

Generational imbalance

It gets worse as time goes on. As the baby boomers retire, transfer payments will take up more and more of GDP, particularly health care payments, but also Social Security and unfunded pension benefits.

Source: "Where's Your Budget Mr. President?" by Paul Ryan, Wall Street Journal, 8/3/11

As can be seen above, if left unchecked government health care spending will continue to gobble up more and more of GDP. The chart above assumes that the rest of the government actually shrinks as a percent of GDP.

So while in the short term today's Keynesians are right, in the long term they are wrong. Our budget deficit is hovering around 10% of GDP, and we still can't stimulate growth. In addition, even though we supposedly have insufficient demand, we are running a trade deficit of 4% of GDP. In other words, even with 9% unemployment and only 76% industrial capacity utilization we consume 4% more than we produce.

We can no longer have a smaller and smaller portion of the population earning a smaller and smaller proportion of income and expect the country to thrive. The welfare state needs to be scaled back to make room for more productive activity.

Seeking American Renewal

While the Republicans are right to focus on scaling back the welfare state, they do not have a good plan for fostering future growth. Scaling back government spending will cut back demand, and the coincidence of super-low interest rates with deficits of 10% of GDP and strong money printing prove there is extremely weak demand for investment capital. It is therefore unlikely that private investment has been crowded out by government deficits.

In the big picture, Obama actually articulates a more credible vision than the Republicans for long term growth…less focus on consumption, imports and residential real estate, more focus on savings, exports and investment, focus on infrastructure investment, technology, education, health care and reducing our reliance on imported oil. His execution, on the other hand, has left a lot to be desired. He was elected to help rebuild the economy and instead dissipated his political capital on his health care bill. Only time will tell if that was the right call or not.

While our political culture is raucous and messy, they are slowly getting it right. Cut back the welfare state, allow private investment to grow and eventually throw the government behind a new growth plan. The focus should neither be on further increasing the returns to investment (the Republican plan) nor on increasing transfer payments (the Democratic plan). We need a plan that gets more people working and making more money. (More on that in a later post.)

In the meantime, all we can do is wait for the real estate downturn to play out before we fire on all economic cylinders again. Until that time, the "Rounded Bottom" scenario holds.