Stock Market Still A Good Investment
Summary
- Robert Shiller, award-winning economist, has just given his reasons for keeping one's investment portfolio more heavily invested in stocks rather than bonds.
- Although stock prices are "expensive compared with past eras" there is still reason to expect them to maintain value or even rise due to the efforts of the Federal Reserve.
- Bonds, on the other hand, are not that good of a longer-run investment as the market points to rising inflationary expectations and the possibility that foreign monies will leave the U.S.
Robert Shiller, Nobel prize-winning economist, is arguing that stock prices are not too high and that compared with bonds, are still the superior investment vehicle.
Unequivocally, the market is expensive compared with past eras.”
Mr. Shiller uses his infamous measurement of stock market value, the CAPE, or, the Cyclically Adjusted Price Earnings ratio, a measure he helped create with John Campbell, now at Harvard, in 1988.
A high CAPE ratio suggests that the market is overpriced, portending low subsequent returns, while a low CAPE suggests the opposite. Professor Campbell and I showed that the CAPE ratio allows us to forecast over a third of the variance of long-term returns on the stock market since 1881.”
The CAPE ratio is 35.0 today, much lower than its highest level, 45.8, which was reached on March 24, 2000, at the peak of the millennium stock market boom. The market fell sharply soon after, and the CAPE has climbed much of the way back, reaching a cyclical high of 35.7 on Feb. 12. Its current range is the second highest since our data began in 1881.”
So, the stock market is high and some day it is going to move so that the CAPE is more around its average value. The thing that the CAPE does not tell us is when. The CAPE is not something one relies on in terms of timing. So, the CAPE could stay at 35.0 for years.
The thing that is keeping stock prices high, relative to earnings, is that for more than 10 years now, the level of the stock market has been highly dependent upon what the Federal Reserve is doing.
And, right now, the Federal Reserve has stated that it will continue to err on the side of monetary ease for the foreseeable future.
In other words, the Fed is going to continue its “easy money” stance for an extended period of time, and is even willing to live with the inflation rate rising above its target level of 2.0 percent for an extended period of time in order to assure that the economy is money upwards at an acceptable pace.
Thus, the CAPE measurement can continue to be at this high level, also, for an extended period of time.
What About Long-Term Interest Rates?
Right now, the yield on the 10-year U.S. Treasury note is around 1.50 percent.
Mr. Shiller suggests that these notes will pay back less in terms of real dollars at maturity than what was originally invested in them. Since stocks are expected to have high long-run expectations (which is confirmed by the CAPE value), stockholders can expect to earn a positive long-term return.
Another argument against investing in bonds right now is that if the Federal Reserve and the Congress are successful right now in stimulating the economy and producing higher levels of inflation, bond yields can be expected to rise as inflationary expectations rise, and bond prices can be expected to fall.
This would be a positive thing for stocks and, under such circumstances, stock prices might be expected to rise again,
As a consequence, Mr. Shiller suggests that investors might want to get rid of some bonds, but should still consider that they should have some balanced amount of stocks and bonds in their portfolios.
What Is Really Going On Here?
Conceptually, the nominal yields on U.S. Treasury notes and bonds are assumed to be composed of two components, one representing inflationary expectations and the other representing the expected real rate of growth of the economy.
Right now, the expected rate of inflation built into the expected yield on ten-year U.S. Treasury notes, is around 2.2 percent. This is up from about 2.00 percent at the end of 2020 and up from about 1.7 percent, since the time of the presidential election last November.
Thus, one could argue that expected inflation has risen by about 0.5 percent since the election, indicating that investors are seeing the Fed’s position, mentioned above, connected with the $1.9 trillion tax program supported by the Biden administration, has caused investors to be more concerned about future inflation.
The “expected” real rate of interest, a proxy for the expected real rate of growth, although it declined for a while during this time period, is now right about where it was in early November 2020. That is, the conditions determining the expected 10-year real rate of interest have not changed much.
The problem is that this expected real rate of interest is negative, about a negative 0.85 percent, and economic growth over the next ten years is not expected to be negative.
So why is this “expected” real rate of interest negative? Well, I have explained this over the past several years as a result of the uncertainty going on in the world where “risk-averse” monies from around the globe are seeking out a safe haven and thus large amounts of foreign money have moved into U.S. Treasury securities and this has resulted in “real yields” dropping below zero.
My argument has been that as long as these “risk-averse” monies remain in the United States, the yield situation in the bond market will stay as it is and has been. That is, investors can expect the yield on U.S. Treasury Inflation Protected securities (TIPS) to remain in negative territory.
As things settle down in the world these monies will move back toward their home markets and the yield on these TIPS will begin to rise and move into positive territory.
Treasury Yields Will Move Higher
The picture being drawn here is the investors, in the future, can expect not only expected inflation to rise in the United States, but they can also expect that “risk-averse” monies invested in the U.S. will one day reverse their flow and leave the U.S. bond markets.
Both of these movements point to higher bond yields in the future, hence lower bond prices.
This is not an optimal forecast for investors that want a longer-run reason to invest in bonds.
Thus, overall, I tend to agree with Mr. Shiller. Stock prices can be expected to stay high or to not collapse as long as the Federal Reserve continues to underwrite the stock market. Bond prices, however, sooner or later, are going to fall and this is not a situation investors would like to have a lot of money invested in. Keep some bonds, if you will, but move your portfolio balance to one that contains a higher proportion of stocks relative to bonds.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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