Why the Equity Naysayers Are Dead Wrong

News reports all over the financial world seem to be declaring the death of stock investing, suggesting that returns from equities over the long term haven't lived up to the hype. But fear not, dear Fool -- rumors of the death of equities have been greatly exaggerated.

Major global banks like Citigroup (NYSE:C) have been shaken to their roots; General Motors (NYSE:GM) is on the brink of bankruptcy; and even Berkshire Hathaway (NYSE:BRK-A) is seeing its debt ratings downgraded. Yet I'm sticking by stocks.

Am I deluded, looking at the wrong numbers, or just plain crazy?

None of the above
Take, for instance, a recent Financial Times article titled "Is it back to the Fifties?" The author cites a paper by Robert Arnott that asserts: "Anyone who started saving 40 years ago, when the postwar 'baby boom' generation was just joining the workforce, has found that stocks have performed no better than 20-year government bonds since then."

One of the main problems with statements like this is that nobody invests the way this assumes. What ready-to-be-retirees do you know who plopped down a big chunk of money one day 40 years ago, and have been counting on that one investment to carry them through their golden years? Not many, I'd imagine.

But as the statement above suggests, an investment made back in 1969 hasn't exactly been a barn-burner. Assuming the investment was in an S&P 500 index, the compounded annual returns were around 5.4%. Of course most baby boomers didn't stop investing in 1969.

Had they invested some more a year later, that investment would have seen an even better 6.4% compounded annual return today. Fast-forward to 1974, and investments would have shown a 7.4% CAGR. And investments made in mid-1982 would have returned nearly 8% per year over the next 27 years.

Perhaps an even bigger problem is that if we're focusing on the time period ending today, we're looking at a stretch that ends with stocks crashing and bonds inflating in a bubble of historic proportions. In fact, today may be one of the most favorable times ever for touting the returns of bonds versus stocks.

But there's more
There's an even bigger issue that often gets overlooked when people start to get calculator-happy, tabulating annual stock market returns. I happen to think this is also one of the most important lessons investors can learn from the current market collapse: Valuation matters.

Yale's Robert Shiller has made a study of past valuations nice and easy for us, by keeping a store of information dating all the way back to 1871. He's even wisely calculated his price-to-earnings ratios based on a 10-year average of earnings to smooth the data. 

Using Shiller's P/E calculations alongside estimates of 10-year forward stock performance, it becomes abundantly clear that there is a definite negative correlation between valuation and future stock market performance. In other words, when the market's valuation is above-average, the highway signs read "low returns ahead."

We've seen this at work with individual stocks. While a great company and strong growth can sometimes justify a high valuation, most of the time, you'll be fighting against the tide when you jump on stocks with sky-high multiples. Back in 2000, investing in Cisco (NASDAQ:CSCO) when its P/E was in the triple digits wasn't such a savvy move. Chasing eBay (NASDAQ:EBAY) and its big valuation in late 2007 hasn't worked out so well, either. Occasionally, those companies were good buys at "rich" valuations, but often, "rich" just makes you poor.

The same holds true for the market as a whole. During the dot-com bubble, Shiller's 10-year P/E measure for the market went well beyond 40, which is way above the historical average. The result? Terrible returns since then. Shiller's P/E measure fell to the mid-to-upper 20s in 2007, which was significantly down from 40, but still well above the long-term average. The result? You know that story all too well.

In fact, if we look back to 1969, when that 40 years of lackluster performance began, what do we find? If you said "A market multiple that was above average," then you win a chocolate chip cookie. I don't think it can be said enough: Valuation matters.

A brave new equity world
So it seems like odd timing to me that now that Shiller's valuation measure has finally fallen back to around its historical average, we're seeing story after story decrying equity investing. To me, this seems like exactly the time to be investing for the long term.

And while investing in a broad market index today might produce good returns, there are plenty of high-quality companies out there, trading at multiples below the rest of the market, that could produce great returns. Diageo (NYSE:DEO), for example, which is responsible for beverage brands such as Guinness, Johnny Walker, Captain Morgan, and Smirnoff, is changing hands at less than 13 times its expected fiscal 2009 earnings. Meanwhile, offshore driller Transocean's (NYSE:RIG) P/E multiple is in the single digits.

Of course, there are few places where valuation matters more than at our Motley Fool Inside Value newsletter service. Philip Durrell and the rest of the team seek out the best companies trading at the absolute best prices. In doing so, they've managed to best the rest of the market over the past four and a half years. You can check out what stocks the team likes in this environment by taking a free 30-day trial of Inside Value.

But even if you don't check out Inside Value, don't forget to take this important lesson with you.Say it with me now: Valuation matters.

Diageo is a Motley Fool Income Investor pick. Berkshire Hathaway and eBay are Motley Fool Inside Value recommendations. Berkshire Hathaway and eBay are Motley Fool Stock Advisor selections. The Fool owns shares of Berkshire Hathaway.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, but does not own shares of any of the other companies mentioned. The Fool’s disclosure policy knows that valuation matters in investing just as proper seasoning matters in cooking.