the stock market ahead

21 Dec

In 2011, I don’t think the stock market deserves to rally. Now, that doesn’t mean it won’t. (To be any good at making predictions, I must hedge.)

I see a few things. Abundant in the media are calls for stocks to rise and bonds to fall, with stocks being cheap. But why can’t stocks and bonds be expensive concurrently? Money will move out of bonds, so the story goes, and into stocks, making one less expensive and the other moreso. (One of my) problem(s) with this is that money flows don’t really tell the story. The stock market is simply trading of already-offered shares held by others. The company is not involved (excluding share buybacks and recaps). When A sells his shares he must sell to B, who pays money to A. B then owns shares and A holds cash. As John Hussman has pointed out, the fact that A brings his cash into the market doesn’t make prices go up, since no cash has actually been added to the market. Instead of A holding shares, B holds them. The same amount of cash is “on the sidelines.” It is the eagerness of the buyer (or seller) that makes prices fluctuate, as stock prices are priced on the marginal trade. Okay, that was a little long to make the point but I think it was necessary.

When I look at stocks broadly speaking (S&P 500 Index) today, I see a market that discounts decade-ahead total returns of just under 6% over the next decade. Since returns tend to be more stable when predicting for longer periods of time, I am most comfortable with this 6%-for-the-decade number. But I’ll list a few others. Five year: 4.5%. Three year: 1.6%. One year: -8.9%.

(A couple things to note here: these numbers are based on my calculation of the intrinsic value of the market and include the current S&P 500 dividend yield of 1.89%. Intrinsic value is based on normal earnings, which use numbers representing long-term averages for earnings growth rates, returns on equity and cost of capital.)

What these numbers tells me is that over a decade returns might end up decent, but not spectacular given the potential drawdowns inherent to stock markets. And it also says if your time horizon is shorter than five years, return prospects don’t look to spectacular (negative on a price-change basis for one- and three-year periods). To use a holiday metaphor, these returns look like a fruit cake. I’d rather have sugar cookies.

It’s always best to judge each asset class relative to the cafeteria menu of available investment options. On that front, bonds don’t look much better. A ten-year Treasury yields 3.3% today, not spectacular and especially with a duration close to 7 certainly not worth a large risk, again, on a risk-adjusted basis. Shorter-term bonds seem the best place to reduce risks in this space – the most salient of which appears to be reinvestment risk. Too, interesting opportunities are emerging in municipal bonds. I may expound on this later.


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