The first three months of 2006 are done. Right now is a good time to think about stock prices and the chances they offer.
Bargains are scarce. Equities are expensive. Several fund managers have told me in the past few weeks that valuations are still good. I don't think so. In general, valuations are not appealing. The return on equity is higher than in the past. A return on equity of 15% across the market is not possible. Price-to-earnings ratios may not show the full cost of a stock. The price-to-book ratio is even scarier.
There are also two other worries. When people talk about how attractive stocks are, they usually talk about the S&P 500 and forward earnings. The S&P 500 is not the best index to use as a guide. It might not be the best index to look at when figuring out how much the whole market is worth.
Estimates are (always) made for future earnings. When current returns on equity can't be kept up, earnings projections that use the same returns on equity may overstate the ability of equities to make money in general. This can happen even when the estimates seem reasonable based on the earnings at the time. If you start with a base income that can't be kept up, you're likely to overestimate your future income, even if you think you're assuming a small amount of income growth.
In general, assets cost a lot of money. If value investors keep insisting on a true margin of safety, they don't have many options.
Bonds are unattractive. Long-term inflation risks make it a bad idea to buy U.S. government, corporate, or municipal bonds. There's not much to gain, but a lot to lose. If a person who doesn't know much about investing buys a high-quality bond today and keeps it for decades, he or she may find that their purchasing power has gone down.
There may be some good chances to make money with foreign stocks. But these things are hard to judge. Foreign government obligations are also hard to evaluate, but value investors don't have much to worry about because most foreign government debt is priced perfectly. If you want to own these bonds, you'll have to be willing to take a lot of risks that won't pay off.
Of course, every rule has some exceptions. There may be some attractive bonds out there. There are certainly some stocks that look good. But even stocks that look very good compared to their peers don't look as good when compared to bargains in the past.
Value investors have a tough choice to make. They can assume that stock prices will go back to where they were in the past and keep their money in the bank until the correction comes. Or, they can accept the way things are right now.
There is no reason why stock prices should have to go back to their old levels. During the 20th century, diversified groups of common stocks had very high real after-tax returns compared to other ways to invest. There have been many ideas about why this happened. Many people have said that these returns were possible because holding stocks means taking on more risk. Long-term, the risks were a bit higher than investors today seem to remember, but they weren't nearly as bad as they were during most of the 20th century, when performance spreads were common.
It was true that if you bought at bad times, you could stay in a pretty deep hole for a long time. But if you didn't think much about the timing of your purchases or the future of the companies whose bonds you bought, you did better than many bondholders who carefully chose their investments.
This is a problem that worries me. Most investors may be too worried about the risk of an immediate "paper" loss in nominal terms and miss the much bigger risk of a gradual loss of purchasing power. If a business or government wants to trick investors, fixed dollar obligations may be the best way to do it.
For the sake of the people who own common stock, I hope that many of the best companies keep issuing these kinds of debt when money is cheap. Corporate debt has a bad reputation because it's often used by people who don't need it and shouldn't want it, as well as by businesses that do need it but won't be able to stay in business even if they get it. Most of the time, the businesses that would benefit most from using debt seem to have more money than they could ever use. But you should try to plan ahead. The cost of capital will change a lot more than the likely return on capital for really good businesses.
If stocks were much cheaper than they should have been over the last hundred years, is there any reason to think they will go back to where they were? The past can often tell us a lot about what will happen in the future, but not always. It's hard to say whether, on average, prices will be higher or lower in the next few decades than they are now. But it's not hard to say whether prices will be higher or lower than they are now at some point in the next few decades. Almost certainly, the answer to that question is yes. They will be both higher and lower. Maybe for a few months or years. Maybe for a full decade. I'm not sure.
I do know that there will be opportunities for value investors to make investments with a real margin of safety. Should they wait, though?
That is the hardest question. When I think back to the best opportunities I've had in the past, I don't see any that look as good as the ones I have now. But I can still find a few (very few) situations in which the expected annual rate of return is more than 15%.
That is more than enough to beat the market. It will also probably be enough to make a big difference in how much you can buy after taxes. That's not a sure thing, but it doesn't seem like holding cash would improve your chances in this case.
So, is an expected rate of return of 15% a good number? Is it smart to bet on the good chance that's available right now instead of waiting for the great chance that might come up later?
I'm going to let you decide.
