The bond market is considered by many to be more rational than the stock market. Thus, when it comes to market and economic commentary, it makes sense to listen to what bond guys have to say.
There's no bond market participant more widely respected than PIMCO bond fund manager Bill Gross. In his September Investment Outlook, posted today, Gross comments negatively on the stock market, arguing market returns are likely to be poor until valuations return to more reasonable levels.
Whether or not you agree with Gross's conclusions, you've got to love his tell-it-like-it-is style. There's no fence-riding for this guy. Right up front, he says: "My message is as follows: Stocks stink and will continue to do so until they're priced appropriately, probably somewhere around Dow 5,000, S&P 650, or Nasdaq God knows where."
Tell us how you really feel, Bill!
Seriously though, Gross makes a compelling case for why the bear market hasn't run its course. Even without a worsening economy, Gross sees stock prices at too high a level to offer reasonable returns. He writes:
... [E]ven under near-normal economic growth rates, the U.S. stock market is priced at current levels to return less than has been historically 'required.' Grow those earnings, they say (although let's be sure what they are), at near historic rates, and you'll still need much lower prices in order to offer stock investors a chance at returns that exceed corporate bonds or even inflation protected Treasuries - TIPS.
Gross bases his conclusions on a careful study of investment returns over the past 100 years. He points out that over that time, the U.S. stock market delivered an average real annual return (i.e., after inflation) of 6.7%. Many have said the stock market's long-term growth is based primarily on earnings growth -- but Gross finds this to be untrue.
In breaking down the 6.7% annual equity return, Gross says the single largest determinant was the initial dividend yield of 4.2%. The second factor behind the rise in stocks was a tripling average P/E ratio, which contributed two percentage points of the 6.7% overall return. Coming in a distant third was earnings growth, which averaged a paltry 0.6% real annual growth over the 100 years. The conclusion? Stocks do not follow earnings growth, as Peter Lynch says on his commercials. Rather, dividend yields matter most to stock returns.
The implications are severe. Gross concludes:
Where does that leave us (you -- not me -- I'm out of the market) today? Well, most large market indices (NYSE, Wilshire 5000) yield somewhere in the area of 1.7%. Whoa now, did I say 1.7%? Yes-siree. And despite the claims for higher implied yields due to stock buybacks (mostly fallacious), even if we grant an 'implied' yield of 2.0% to the market, it's hard to see how we can get to our 6.7% real return target.
What's a Fool to do? It's not necessary to exit stocks entirely -- just the highly valued ones. Now's the time to critically examine your portfolio and make sure you're positioned in undervalued stocks -- those with valuation metrics far less than the S&P 500's average P/E of 21.5. If you don't know how to find such stocks, we offer The Motley Fool Select and Motley Fool Stock Advisor, two monthly services to help you identify great companies with undervalued shares.