In early July, I wrote that from a value investor’s long-term perspective, stocks seemed cheap. The S&P 500 SPX,
rose 10% over the next five weeks, before falling back to near where it was in early July. Let’s revisit the question, again from a value investor’s perspective, this time using three benchmarks I’ve described in previous MarketWatch columns.
John Burr Williams, the original value investor, showed that the long-term return on stocks is roughly equal to the dividend yield plus the long-term growth of dividends. For example, a dividend yield of 2% plus a growth rate of 5% implies a stock return of 7% over the long term. One way to think about this is that stock returns are made up of dividends plus capital gains, and if dividends grow at 5% per year, we can expect stock prices to rise about 5% per year over the long term as well.
On March 11, 2000, I spoke at a conference about the booming stock market and the widely publicized “36K” forecast that the Dow Jones Industrial Average DJIA,
would soon more than triple, from less than 12,000 to 36,000. The dividend yield of the S&P 500 was 1.16% at the time. Adding a long-term growth rate of 5% for dividends, the John Burr Williams approach implied a long-term return of 6.16% for equities, which was lower than the 6.26% yield on 10-year US Treasury bonds TMUBMUSD10Y,
Taking into account two other benchmarks that I will discuss below, I concluded my presentation with the warning, “This is a bubble and it will end badly.”
In December 2008 I was interviewed about the stock market. The S&P 500 fell 40% from March 2000 and the unemployment rate in the US was 7.8% and rose as the economy raged into the Great Recession. Who would be crazy enough to buy stocks? I was. The S&P 500 dividend yield was 3.23% and a 5% growth rate implied a long-term 8.23% return from stocks, which was 5.81% above the 2.42% 10-year yield at the time. I said this was the buying opportunity of a lifetime.
What about now? The S&P 500’s dividend yield is currently 1.63% and a dividend growth rate of 5% implies a long-term yield of 6.63%, compared to a 10-year yield of 3.20%. The difference between stocks and bonds at closing on September 7 was 6.63% – 3.27% = 3.36%, about halfway between the difference of –0.10% in March 2000 and the difference of 5.81% in December 2008 – halfway through a bubble and a buying opportunity of a lifetime
A second measure is Shiller’s CAPE. I invert CAPE to give what I call CAEP = 1/CAPE. This benchmark, the cyclically-adjusted earnings yield, is an estimate of the long-term real (inflation-adjusted) return on equities and can be compared to the real return on Treasury bills. In March 2000, the CAEP was 2.31, which was 1.45% lower than the real yield of 3.76% on 10-year government bonds (at an inflation rate of 2.5%). This reinforced my conclusion that the market was in a bubble at the time.
In December 2008, the CAEP was 6.61%, which was 6.59% above the -0.08% real yield on government bonds, reinforcing my view that this was a rare buying opportunity. The CAEP is now 3.40%, which is 2.7% higher than the 0.7% real government bond yield (again assuming a long-term inflation rate of 2.5%). If you assume higher inflation, equities look even more attractive.
My third benchmark uses John Bogle’s understanding that the percentage change in stock prices equals the percentage change in earnings plus the percentage change in the P/E ratio. I use Bogle’s insight with a variety of assumptions for future P/E values and I will not go into the details here for March 2000 or December 2008; they can be found in my book “Money Machine: The Surprisingly Simple Power of Value Investing.” Suffice it to say, they reinforced my conclusions at the time when March 2000 was a bubble and December 2008 was a great buying opportunity.
Currently, the dividend yield is 1.63% and the S&P 500 P/E is 19.84. If dividends and earnings grow at an average of 5% per year and the 10-year P/E ratio is still 19.84, the annual return of the S&P 500 will be 6.63%. Instead, if the S&P 500 P/E is 15 or 25 in September 2032, the annual S&P 500 return will be 3.88% or 8.97%, respectively, which can again be compared to the current 3.27% 10 -year Treasury rate.
The proverbial underline. The John Burr Williams approach indicates that the long-term yield of stocks is currently 3.36% above the long-term yield of 10-year government bonds. CAEP indicates that the difference is 2.70%. The Bogle approximation gives a range for the difference from 0.55% to 5.64%.
You can use these three boxes with your own assumptions to draw your own conclusions. My conclusion is that stocks seem like a significantly better long-term investment than 10-year Treasuries, but not for a once-in-a-lifetime amount. From that perspective, the US stock market doesn’t look even remotely vibrant.
Gary Smith is the Fletcher Jones Professor of Economics at Pomona College. He is the author of “The Money Machine: The Surprising Power of Value Investing” (AMACOM 2017), author of “The AI madness,“(Oxford, 2018), and co-author (with Jay Cordes) of “The 9 pitfalls of data science(Oxford 2019).
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Plus: Preferred stocks can provide hidden opportunities for dividend investors. Just look at this example from JPMorgan Chase.