Though a dose of optimism has crept into the news lately, there are still plenty of people who 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 financial institutions like Goldman Sachs (NYSE:GS) and American Express (NYSE:AXP) are facing once-in-a-lifetime challenges in their sector; quasi-government lender Fannie Mae (NYSE:FNM) (despite the increase in its stock price) is on very shaky footing; and even Berkshire Hathaway's debt ratings were 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 Financial Times article from earlier this year 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.
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 6%. But most baby boomers didn't stop investing in 1969.
Had they invested some more a year later, that investment would have brought an even better 6.8% 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 8.5% 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 has 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 significantly 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.
Investing in General Electric (NYSE:GE) in 2000 when its P/E was hovering around 50 wasn't such a savvy move. Chasing Verizon (NYSE:VZ) and its big valuation in 2005 hasn't worked out so well, either. Occasionally, companies are 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 tasty 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 dropped and is vacillating 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.
Petrobras (NYSE:PBR), for example, an oil and gas powerhouse out of Brazil, is changing hands at less than 10 times its trailing earnings. Meanwhile, health insurance giant UnitedHealth (NYSE:UNH) trades at a similar single-digit multiple.
Of course, there are few places where valuation matters more than at our Motley Fool Inside Value newsletter service. Philip Durell 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.
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This article was originally published May 20, 2009. It has been updated.
Fool contributor Matt Koppenheffer owns shares of American Express and Berkshire Hathaway, but does not own shares of any of the other companies mentioned. Berkshire Hathaway and UnitedHealth Group are Motley Fool Stock Advisor picks. American Express, Berkshire Hathaway, and UnitedHealth Group are Inside Value picks. Petroleo Brasileiro is an Income Investor selection. The Fool owns shares of Berkshire Hathaway and UnitedHealth Group. The Fool's disclosure policy knows that investing without paying attention to valuation is like trying to pitch in the major leagues without a fastball.
