Don't Let Jonathan Chait Draw Your Bathwater!
Wolfowitz Report: More Journamalism from the New York Times

An Attack on Jeremy Siegel...

Hussman is unhappy with Jeremy Siegel:

Hussman Funds - Weekly Market Comment: April 30, 2007 - Double Counting: In a little piece of hubris published in the Financial Times by Jeremy Siegel (who is increasingly becoming a modern-day Irving Fisher), investors were told:

Since the long-term real growth of per share earnings is also only about 2 per cent, pessimists project real returns of only 4 per cent in the stock market, well below the 6.5 to 7 per cent average real returns that the historical data have indicated.

Real returns can be estimated from the earnings yield, the reciprocal of the more popular price-earnings ratio. Since stock earnings are based on real assets, the earnings yield provides a good estimate of the real return on the stock market.

In the US , the long-term average p/e ratio has been 14.4 times, which corresponds to a 6.9 per cent earnings yield. This is extremely close to the historical average real return on equities. 2007 estimates for earnings on the S&P 500 Index range from $87 to $91 per share. With the index at 1,450, this leads to a current p/e ratio of between 15.5 and 16.5 times and a corresponding earnings yield – and hence real return – of 6.0 to 6.5 per cent on S&P 500 stocks. Even though current returns on stocks look good, future stock returns may even be higher....

[W]hy does Siegel say that the earnings yield is an estimate of the real return on stocks? Think of it this way. Reported earnings subtract out depreciation, which is another way of saying that earnings are reported as if the company reinvests only enough to replace depreciation and keep its stock of productive assets constant over time. If the company were not to invest anything for growth, it would theoretically be able to pay out all of its net earnings as dividends. If earnings on the fixed stock of capital could grow at the inflation rate by virtue of monetary factors alone, you would get zero real earnings growth. Then holding valuations constant over time, the earnings yield would be a measure of the real return on stocks. Fine if you believe the assumptions. Now let's look at the data.

The first problem is that in order to produce 2% real annual growth in earnings per share, companies have historically devoted about 50% or more of their earnings to reinvestment and repurchases - over 300 basis points of that earnings yield to get 200 basis points of real growth. That's a tip-off that historically, competitive pressures have prevented earnings from simply growing at the rate of inflation without new investment. You had to invest new money to get your earnings growth up to the inflation rate. In general, once your return on invested capital falls to the point where you're willing to buy your own stock instead of making new investments, the simple earnings yield overstates probable long-term real returns (especially if the yield is based on record earnings). In fact, about 1% of the long-term real return on stocks has come from an increase in the overall level of valuation in recent decades. Absent that increase in valuations, the real return on stocks would actually have been at least 1% less than the average long-term earnings yield.

Next, the historical average p/e Siegel cites is based on trailing net earnings, not forward operating earnings. Also, current earnings figures reflect unusually wide profit margins. On the basis of trailing net earnings even modestly normalized for profit margins, the relevant p/e for the S&P 500 is currently above 20, and actually closer to 25. That puts the applicable, normalized earnings yield at about 4-5% here. Give that a 1% haircut as explained in the foregoing paragraph, and assuming that p/e valuations don't contract in the future, you could expect a long-term real return of 3-4% from stocks going forward. Add in inflation of 2-3% and the long-term nominal total return priced into stocks here (say, on a 20-30 year horizon) is probably somewhere between 5-7% annually.

Over a shorter horizon, say 5-7 years, the likely real and nominal returns on stocks will probably be lower. At GMO, Jeremy Grantham estimates (and my work largely agrees) that the real return on stocks over the coming 7 years should be about -2% annually (about zero in nominal terms). GMO calculates its estimates for a wide variety of asset classes, including bonds, foreign stocks, and so forth. Grantham noted last week that “We now show – drum roll – the first negative sloping return/risk line we have ever seen. The process of moving all asset prices to fair value over 7 years (which is how we do our 7-year forecasts) will have resulted in a world where investors are paying to take risk!”

If investors believe that stocks should be priced to deliver long-term returns of 5-7% annually, then yes, stocks might be fairly priced here.

Even optimistic assumptions and alternative models produce only modest changes to long-term expected returns. For example, optimists might take the current earnings yield of 5.5% (a trailing price/peak earnings multiple of over 18) as sustainable, assume that profit margins will never come down, assume all earnings can be paid out as dividends, and assume earnings will achieve nominal 2% growth anyway due to inflation alone. In that case, stocks would be priced to deliver a 7.5% long-term annual return. Alternatively, optimists can assume that earnings will continue to grow along the peak of their historical 6% peak-to-peak earnings channel (a point from which earnings have always been vulnerable to long periods of tepid growth), and that valuations and profit margins will remain permanently elevated. Adding in a further 1.8% dividend yield, they might even estimate stocks to be priced for a 7.8% annual return.

It's very difficult, however, for a reasonable analysis to project long-term returns on stocks much higher than about 7.8% over a 20-30 year horizon. Again, 5-7% is more likely in my estimation, with nominal total returns on stocks close to zero over the coming 5-7 years.

The criticisms appear to be three:

  • Accounting earnings overstate true Haig-Simons earnings needed to maintain real profitability by about 1% of market value.
  • We want not earnings but earnings adjusted for the business cycle, which would give another 1% of market value haircut to earnings.
  • We want price-to-trailing-earnings, not price-to-current earnings, which would give an additional haircut of 0.1% of market value to earnings.

Add up these three criticisms, and you get an adjusted earnings yield of not 6.3% but 4.2% as the long-run real return to equities.

I tend to split the difference, sitting at 5.3%, and sharing Hussman's great anxiety about the medium-term. Of course, if the medium-term turns south one way it might turn south is with substantial inflation, so bonds are not an attractive hedge. Real estate is also not an attractive hedge. A combination of European and emerging market equities looks to be the best thing you are going to get.