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Thursday, March 27, 2008


the longer-term picture

bespoke highlighted an interesting article above the fold in yesterday's wall street journal -- with its own insightful spin.

We took the 10-year total return performance of the S&P 500 back to 1900 (non-inflation adjusted) and charted the results below. When the line is highlighted in red, 10-year returns were lower than they are now. As shown, periods where returns were lower occurred in 1914, 1921, 1932, 1938, 1974 and 1977. We also highlight years where returns peaked -- 1929, 1959, 1992 and 2000. While the returns could easily get worse, periods that have been this bad have not lasted longer than 4 years (1937-1941) before they've started to get better.

four years is a long time -- and it is perhaps better contextualized by this post from angry bear.

Today's WSJ article gave the impression that the lost decade should be setting the stage for a period of superior returns as the market returns to the mean. But this chart implies that the market still has a lot of downside as the market PE has only fallen to about its long term average and still has a tendency to fall to below 10.

these earnings ratio compression journeys typically run something on the order of 15 years (give or take a few, of course). if the current one can be said to have begun in 1998, we're already about ten years in. of course, we're also coming off the most exorbitantly-overvalued market peak in the series, and remain near a p/e of 15 with a probable destination in the area of 7.

on the former chart, i'd note that ten years ago was 1998 -- and the dates of the high and low return points are at least as informative by subtracting ten years as they are themselves. this measure of total return is likely to get worse going forward simply because the market raced higher in a colossal blowoff into march 2000. note that the current reading is still +60% for the period, compared with trough returns on the order of 0% to (-40%). not only is four years a long time, but there's plenty of room for downside to reach minimum returns that have considerable precedent.

on the latter (adn more important) chart, if earnings growth continues in the range of 10% a year -- not a given by any means -- that would raise underlying earnings by nearly 50% in four years. that would lower p/e from 15 to about 10. the implication would still be a haircut in price of some 30%. and frankly the notion of persistent 10% earnings growth seems a bit farfetched given the state of the financial system.

therefore, i would suggest that the likely course of aggregate stock prices is significantly lower in real terms.

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