If asked if their investments in
equities will outperform Treasury bills over the next 10 years, most investors
would probably not hesitate to answer yes. After all, it is axiomatic that
stocks perform well over the long term, and that they regularly outpace T-bills.Yet, these investors might be surprised to know that history suggests an
outcome that is altogether different. Today, U.S. equities are trading at more
than 20 times the value of their cyclically adjusted earnings, an occurrence
that, until recent years, had been very rare. Even with a 10-year time horizon,
buying equities at such elevated valuations has historically proved dangerous
for investors. It is true, of course, that stocks perform well over the long
term, but the useful definition of the "long term" is a time period much longer
than 10 years. As professor Jeremy Siegel points out in his book,
Stocks for the Long
Run, equities "have never offered investors a
negative real holding period return yield over periods of 17 years or
more."
Two-hundred years of historical data suggest that as long as
investors hold on to equities for more than 17 years, their investments will
grow in real terms. The same data suggests that 10-year periods do not offer the
same impressive returns. In fact, there have been numerous occasions during
which T-bill returns have, over a 10-year period, outpaced equity returns. These
periods have something in common: At the beginning of the period, equities were
overvalued. In fact, they were not even overvalued to the point at which they
are overvalued today. In their 2000 book, Valuing Wall Street, authors Andrew
Smithers and Stephen Wright assess the record of all key-valuation metrics for
stocks. In this book (and in their subsequent work), they conclude that the best
way of measuring value is by looking at stock prices relative to the replacement
of value of corporate assets and also relative to cyclically adjusted earnings.
It is in relation to these two tried-and-tested measures of value that it
becomes quite clear that U.S. equities are currently overvalued or "expensive."
If we focus just on the value of equities relative to their cyclically adjusted
earnings, then stocks are as expensive today as they were in 1928—on the eve of
the great stock market crash. 
Equities now have a valuation that is 25 times cyclically
adjusted earnings, which suggests they will perform poorly relative to T-bills
over the next 10 years. The market reached such valuations nine times between
1925 and 1991. On seven of these occasions, T-bills provided better returns for
investors than equities over the subsequent 10-year holding period. The good news is that perhaps history is, as Henry Ford
famously proclaimed, bunk. By 1992, for example, equity valuations had once
again risen to a level normally associated with poor returns. Yet, stocks kept
rising until they reached more than 40 times cyclically adjusted earnings.
Today, valuations are as high as they were during the 1992 to 1996 time frame
and have yet to collapse. However, if the so-called bubble market of the 1990s
was indeed an aberration, then history suggests that investors are much more
likely to get higher returns from T-bills than equities over the next
decade. So perhaps the lessons learned from the 200 years prior to 1991
are truly bunk. Maybe the gravity of value, evident throughout that period, has
been permanently suspended. Investors in U.S. equities had better hope so.
Illustration by Matt Mahurin.  | Russell Napier is a consultant with CLSA Asia-Pacific Markets and
the author of Anatomy of the Bear:
Lessons From Wall Street’s Four Great Bottoms. |
|
