As I've noted in previous commentaries, one obtains similar results even using forward operating earnings, provided that the model factors in the variation in growth rates that is driven by fluctuations in profit margins. Unlike dividends or Shiller (10-year average) earnings, operating earnings have a larger cyclical component due to expansion and contraction of profit margins. The more variable the fundamental, the more important it is to model variation in the growth rate. Having done that, however, a variety of fundamentals provide very similar long-term return implications. The implications are particularly uninspiring over a 5-7 year horizon, where our total return projections range between 0-3% depending on the fundamental used. The corresponding 10-year projections are in the 3-5% range.
For comparison, I've presented the identical analysis below using Shiller P/E ratios rather than dividend yields. For this version, I've defined bubble valuations as Shiller P/E ratios of 21 and above, which have historically been followed by poor long-term returns.
The implications of Shiller P/E ratios are slightly more constructive than those from dividends. As I noted last week, the ratio of dividends to various earnings measures is somewhat low at present, reflecting outright dividend cuts in recent years, combined with elevated profit margins. Some would also argue that share repurchases should also be counted as dividends, but as the function of share repurchases is largely to offset the dilution that results from option grants to employees and corporate insiders, I strongly disagree. Nevertheless, Shiller earnings are not subject to that debate, and are less sensitive to shorter-term variations, providing a "smoother" fundamental. Our 7-year total return projection for the S&P 500, based on Shiller P/E ratios, is approximately 3% at present. Again, investor expectations for substantially higher returns over the coming years rely on bubble valuations to be maintained and extended indefinitely. This is not impossible, but there is no margin of safety in that requirement.
Economic notes
Citing "imminent funding pressures" in the global banking system, the IMF released a report last week suggesting the potential for a fresh round of bank stress. The primary focus of concern was the European banking system, due to "relatively greater pressure in European banking systems from both sovereign risks and wholesale funding strains," but the IMF indicated that U.S. banks may also need to raise additional capital "to reverse recent deleveraging trends, and possibly to comply with U.S. regulatory reforms." The IMF warned that "Conditions in the global financial system now have the potential of jumping from benign to crisis mode very rapidly."
It will come as no surprise that we agree, but at least for now, investors evidently could not care less. Had investors been correct in ignoring the ultimately disastrous risks of the dot-com bubble, the tech bubble, the housing bubble, and the overleveraging of U.S. financial institutions that preceded the recent credit crisis, we would concede that the market's wisdom on these issues should take precedence over our own concerns. But in our view, those disasters were predictable. Likewise, as noted above, the persistent willingness of investors to misprice stocks is exactly why they have gone nowhere for over a decade. We'd love to be bulls, scampering happily about. But that would be helped if stocks were priced appropriately and if there was not a large anvil suspended on a fraying string overhead.
We strongly believe that price and volume behavior conveys information, but that belief does not extend to the dogma that they do so perfectly, or that prices are "sufficient statistics" for the overall state of the world (which would make analyzing additional data useless). Rather, our view is that the stock market is substantially overvalued here, and that investors continue to be diverted from the big picture by the clown carnival of short-term news and investing-as-sport that is celebrated on financial television.
The global financial system continues to be unsound in the same way that a Ponzi scheme is unsound: there are not enough cash flows to ultimately service the face value of all the existing obligations over time. A Ponzi scheme may very well be liquid, as long as few people ask for their money back at any given time. But solvency is a different matter - relating to the ability of the assets to satisfy the liabilities.
