What if I'm wrong?
It's a simple question that I'm not sure enough investors ask themselves. I'll readily admit that I am often more confident than I should be in my expectations -- particularly when they apply to an unknowable future.
Recently, I've been taking a close look at the current valuation for the U.S. stock market -- primarily by way of professor Robert Shiller's cyclically adjusted price-to-earnings ratio (CAPE). The conclusion I've come to is that after a near-100% gain in the S&P 500 that's taken the CAPE to almost 24, the stock market is looking pricey.
But what if I'm wrong?
As I noted in my article yesterday, a bunch of Foolish readers weren't on board with my take. Fortune writer Jeffrey Westmont penned an article yesterday that put forward a number of reasons why it may not be wise to draw any conclusions about the market based on the CAPE. In addition, offline, my fellow Fool Morgan Housel vehemently countered my assertion.
Morgan pointed out that thanks to globalization and the birth of 401(k) retirement plans, there's simply more capital chasing stocks, which may permanently keep valuations higher than they've been in the past. The numbers seem to back up this shift to higher average valuations as the average CAPE over the full data series (going back to 1871) of 16.4 has been exceeded by the average of 19.4 going back to 1960 and that, in turn, has been topped by the average since 1990 of 25.7.
If that final 21-year average most closely represents current market reality, we could even argue that today's CAPE may be showing that stocks are actually undervalued.
But here's the problem
If all else remains equal, the more we pay for a dollar of earnings when we buy stocks, the lower our returns will be. Let's say, for example, we knew how much cash a certain business was going to generate in the future. Our rate of return for investing in that company would be determined by how much we pay for that cash stream -- the more we pay, the lower our returns.
If stock valuations are continually climbing to new rungs of higher sustainable average levels, then the good news is that we may not be in for the huge market sell-off some analysts are predicting. However, it also means that investors will have to readjust their expectations for lower returns.
If all else remains equal
That's a pretty big supposition, so we better kick the tires a bit. Higher valuations for the market might not impact returns if companies' profit growth speeds up. To figure out how likely that is, we can look at the two main drivers of profits -- revenue growth and profit margins.
Since we're talking about marketwide trends, we can probably make the assumption that overall revenue growth will roughly track with GDP growth. But that doesn't bode well for accelerating growth, as U.S. GDP growth has been slowing through the years.
Of course there's a valid argument that many U.S.-based companies are less dependent on U.S. growth now that we live in a globalized world. Las Vegas Sands (NYSE: LVS) may be based in Las Vegas, but most of the company's opportunities -- and much of its current profits -- come from outside the U.S. in places like Macau and Singapore. Likewise, EMC (NYSE: EMC) takes in roughly half of its business from outside the U.S. Heck, even an all-American company like Ford (NYSE: F) gets only about half of its total revenue from the U.S.
This makes the possibility of faster growth a little more likely as world GDP growth has been trending upward.
Notably, that increased growth has been driven almost in whole by surging emerging markets as growth in developed markets has looked a lot more like growth in the U.S. So the opportunity for faster growth really only has credence to the extent that companies are receiving a significant chunk of their offshore revenue from the emerging markets.
As for profit margins, they've been very healthy lately, but there's a large contingent of analysts who argue that profit margins are mean-reverting and therefore are due to contract. My fellow Fool Alex Dumortier looked at this issue last summer. Suffice it to say that we probably shouldn't be counting on continued growth in profit margins to drive earnings growth.
You better beat the market
So where does this leave us? I figure there are three broad scenarios as far as valuations go:
- Valuations are too high and will revert to their long-term average.
- The fair-value multiple for the market has risen, and that means that long-term equity returns will be lower than in the past.
- The market's fair-value multiple has risen, but corporate profit growth will keep returns at historical levels.
I won't completely count out the third scenario, but for that to happen it seems we'd have to rely on emerging markets just as they're trying to slow down their smoking-hot economies to avoid inflation problems. As for the other two scenarios, both essentially mean the same thing for investors: Lower stock market returns than what we're used to.
That means that investors may face the choice of cranking down their returns expectations or having to find a way to beat the market's return. Though the latter is by no means easy, most Fools believe that individual investors have the ability to do just that.
My personal strategy for targeting above-market returns hinges largely on a focus on dividend-paying stocks, which are a group that handily beat the market over the past decade. And fortunately, we don't have to think that the overall market's valuation is attractive to grab compelling dividend stocks. I recently highlighted the potential opportunity at Lockheed Martin (NYSE: LMT), a stock that yields 3.7%. Morgan Housel listed Verizon (NYSE: VZ) as "a company you can buy today" -- it yields 5.4%. And finally, Teva Pharmaceutical (Nasdaq: TEVA) pays a low 1.3% dividend, but, as my fellow Fool Brian Richards pointed out, the dividend has grown at an impressive 30% CAGR over the past decade.
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