The Bull at 5: Where Do Stocks Go From Here?

Happy 5th birthday, Mr. Bull Market -- it seems like only yesterday that you sprang from the loins of a dying Bear. Yet, on March 9, 2009, the S&P 500 (SNPINDEX: ^GSPC  ) put in its crisis low of 676.53. Investors had given up on stocks in an environment in which they were being bombarded with seemingly catastrophic headlines on a daily basis.

Seven days earlier, troubled insurer AIG had reported a $61.7 billion loss for the fourth quarter of 2008 -- the largest loss in U.S. corporate history. Two days after that, General Motors disclosed to its shareholders in its annual report that "there is substantial doubt as to our ability to continue as a going concern" (the company was ultimately restructured under bankruptcy protection.) On March 9, the CBOE Volatility Index (VOLATILITYINDICES: ^VIX  ) , or VIX, which is sometimes referred to as Wall Street's "fear index," closed at 49.68 -- it has not closed above that since then.

What did we know then?
Instead of imminent doom, however, investors might have anticipated that, barring outright economic collapse, there was a decent chance that stocks would perform reasonably well over the next five years (though the market's actual performance has exceeded what one could have hoped for).

Why?

Valuations. On March 9, the S&P 500's cyclically adjusted price-to-earnings ratio, or CAPE, stood at just 11.9 -- cheaper than it had been at any point since 1986 (the cyclically adjusted price-to-earnings ratio, a metric popularized by Nobel laureate Robert Shiller, compares stock prices to an average of inflation-adjusted earnings per share over a trailing-10-year period).

And so it was that the fear and revulsion that brought low risky assets in general, and equities in particular, set the foundations for a stunning bull market:

^GSPC Chart

^GSPC data by YCharts

For the S&P 500 (blue line), which now boasts a 178% price return, a triple is almost in sight, if not immediately within reach. Note that the broad market, as represented by the Wilshire 5000 index (orange line) has done even better, thanks to the huge outperformance of small-capitalization stocks; the Russell 2000 (red line) has well more than tripled over the past five years. (Although the S&P 500 is the most widely used measure of the market's performance, it's technically a large-capitalization index.)

Where do we go now?
But where do those gains leave valuations today and what does that augur for returns over the next five years?

As of Friday's close, the S&P 500 now sports a corpulent CAPE of 25.6, going from a 27% discount to its long-term historical average five years ago, to its current 55% premium. That puts the CAPE into the highest 10% of its values over its entire history going back to 1881.

As hedge fund manager Cliff Asness observed in a November 2012 paper, historically, when the CAPE is within the top decile of its values, subsequent stock market returns are mediocre, with a 10-year real return that has averaged just 0.5% on an annualized basis (it's important to note, however, that the range of returns is very wide, varying from (6.3%) to +6.1%).

Last month, another well-regarded value investor, James Montier of GMO, published a white paper describing two methods to forecast real returns over the next seven years based on the CAPE. The more optimistic estimate called for an annualized return of just +0.8%, while the more pessimistic produced a (3.2%) loss! Those ought to be sobering figures, particularly for individual investors who have only now begun to drink directly from the equity market punchbowl.

With the prospect of such mediocre returns, should investors be selling their stocks instead of buying? My answer is "no." As my Foolish colleague Morgan Housel has highlighted, the CAPE isn't perfect (though I would argue it's the best metric we have) and even with a high starting CAPE value, the range of outcomes in terms of performance is very wide. As Cliff Asness points out:

I would, if trading on a tactical outlook, give the Shiller P/E some small weight, particularly when it's above 30 or below 10. But I think this type of analysis is most useful not for a trading strategy but to set reasonable expectations.

If you are a "know-nothing" investor (there is no shame in this -- it's the path almost every investor should adopt), the lesson is to temper one's expectations for future stock market returns -- the next five years are unlikely to mirror the past five and they could end up being very disappointing relative to stocks' historical average return (roughly 6.5% per annum, after inflation). Still, if you have an equity-appropriate time horizon, you can continue to put money into a low-cost index fund at regular intervals.

2 values in a heated market
If you have some skill, experience, and time -- and the inclination to pick individual stocks -- know that it's becoming increasingly difficult to ferret out names that trade at a discount to (or even at) their intrinsic value. However, there are still some values out there. Take the insurance sector, for example: MetLife (NYSE: MET  ) , the No. 1 publicly traded life insurer in the U.S., is a wonderful franchise, yet it is valued at less than 9.5 times the next 12 months' earnings-per-share estimate -- a significant discount to the overall market. Viewed from another angle, it does not take much in the way of returns on equity to justify the stock's 21% premium to its tangible book value.

Another insurance-related name, Berkshire Hathaway (NYSE: BRK-B  ) , looks reasonably priced. In his recently released annual letter to shareholders, CEO Warren Buffett wrote that stock repurchases at 120% of book value "benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount." On Friday, Berkshire's shares closed at 136% of book value. My sense is that when Buffett refers to a "meaningful amount," it's more than the difference by which 136 exceeds 120.

When it comes to individual stocks or the broad market, valuation has predictive value with regard to future performance. Right now, the U.S. stock market doesn't look particularly cheap, and while that tells us nothing about the market's direction in the near term, it's an anchor on performance over the medium to long term. Just as investors who extrapolated bear market losses into the future five years ago were wrong, those who extrapolate similar gains to those achieved over the past five years could well be making the same mistake today.

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Read/Post Comments (8) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 10, 2014, at 7:29 PM, cmalek wrote:

    If you listen to the analysts, they will tell you the market will either keep going up or it will tank. So act accordingly.

  • Report this Comment On March 10, 2014, at 7:44 PM, awallejr wrote:

    Well I have been investing under the thesis that we are in a secular bull market. Much is made how much the market is up from the 3/09/09 low but from its 2007 high it is only up about 15% excluding dividends.

    This will continue to be a story of "in search of yield." FED isn't raising interest rates dramatically to make cash more appealing since we still don't have an overheating economy nor serious inflation to warrant that.

    Also this is an issue of demographics as well. People retired tend to spend less and that will impact GDP unless the boomers are replaced, which would require immigration reform. But Republicans won't let that happen.

    So I see this market grinding ever higher with shallow pullbacks that hit hard and fast and then get bought. Now should we go into a recession that is a thesis changer as well as some geopolitical or Washington created black swan.

    But right now I look at that chart above and say there is no reason that chart can't continue higher.

  • Report this Comment On March 10, 2014, at 9:45 PM, daveandrae wrote:

    Blah, blah, blah.

    If you think stocks are expensive, try looking at bonds, which are even more expensive and yield nothing after inflation and taxation. If you think both stocks and bonds are expensive, look at cash, which is even MORE expensive than both stocks and bonds, currently yielding a negative real rate of return when the aforementioned twin towers of reality are applied.

    Why you people try to make something that's relatively simple to understand so ridiculously complicated is beyond my level of comprehension.

    At the end of the day, an equity portfolio is either a better investment than cash, or it is not. E-v-e-r-y-t-h-i-n-g else is nothing more than commentary.

  • Report this Comment On March 11, 2014, at 9:34 AM, KombatKarl wrote:

    No one can predict what the market will bring in the next 5 years. But history shows that bear markets have fundamental reasons for happening, and there is nothing on the horizon that suggests this is a possibility any time soon. Corrections happen out of fear, and quickly bounce back almost as fast as they came. Returns may not be as good over the next few years as they have been the past few, but I don't see any reason for the overall bull market to not continue.

  • Report this Comment On March 12, 2014, at 1:26 PM, MichaelDSimms wrote:

    "When it comes to individual stocks or the broad market, valuation has predictive value with regard to future performance. Right now, the U.S. stock market doesn't look particularly cheap, and while that tells us nothing about the market's direction in the near term, it's an anchor on performance over the medium to long term."

    Agree most stocks are too expensive. A few are fairly priced. I predict a pullback soon, overall. With 17 Trillion of debt and climbing look to gold to make some moves this year.

  • Report this Comment On March 14, 2014, at 3:24 PM, UkeBill wrote:

    I'm a relatively new investor so please cut me some slack if this seems too basic.

    My question is.. I see BRK-B being recommended in a few places here. When I look at the chart as compared to SPY.. I'm wondering why the recommendation. I'm sure there is a ton I don't understand about this. But it appears SPY has less volatility than BRK-B

    Thanks.. Bill

  • Report this Comment On March 14, 2014, at 3:34 PM, Telsaar wrote:

    I like the P/E concept, but to watch the price is misleading. Watch how earnings grow, dive or sit still. If earnings grow, the Stock Market will continue to go out the top of the chart. However, we are in a political climate where those in charge want to pick the winners and losers. So far they have wasted money on losers. Which makes a loser out of all of us. Economic policies favor under developed green energy and environmental activist. They want to shut down our energy resources before proven replacements have availed themselves.

    The economy wants to take off, but the hurdles keep getting higher in favor of special interest (green energy, environmentalist and health care). We have to watch the fight to see who wins. If you ask me who is going to succeed my answer is "I don't know."

  • Report this Comment On March 14, 2014, at 5:25 PM, richak28 wrote:

    In my humble opinion many are going to bite the dust before this year is done... Trees only grow so high and stocks do not continue higher forever... a BEAR is staring you in the face now... Be careful ...

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