The financial industry has always seen arguments among stock market bears who view stocks as overvalued, poised for a drop, and bulls who see stocks as undervalued, positioned for a run-up.
Seldom, however, has there been the kind of division in sentiment about stock market prospects that we see today.
Early March marked the one-year anniversary of last year's stock market lows and the 10-year anniversary of the tech bubble high of early 2000.
In recognition of those anniversaries, The Wall Street Journal ran a feature story profiling the leading proponents of the undervalued and overvalued cases - Wharton's Jeremy Siegel, author of Stocks for the Long Run and Yale's Robert Shiller, who wrote Irrational Exuberance.
Notably, both had been on the record in early 2000 saying that tech stocks were overvalued and trading at unsustainable levels. Since that time however they have diverged on their assessments of stock market valuations.
In early July, I travelled to Philadelphia and New Haven and spent an hour each with Professors Siegel and Shiller, who coincidentally are long-time friends who regularly vacation together on the Jersey Shore.
The negative view
The foundation for Prof. Shiller's views is an examination of corporate earnings adjusted for inflation over the past 10 years - looking back 10 years tracks earnings through a full business cycle and eliminates short-term distortions in any given year.
Over the past 150 years, stocks have traded at an average multiple of 16 times the average of 10-year earnings. When beneath this level, stocks are cheap and have tended to do well in the following period; when above this level, they're expensive and have often underperformed in the years that follow.
Today, stocks trade at around 20 times 10-year earnings. While not close to the peak level of 40 times, historical earnings they hit in 2000, this is still historically expensive - and suggests subpar returns in the period ahead relative to the long-term average for stocks of 9 per cent before inflation and 6 per cent after inflation.
In our conversation, Prof. Shiller also expressed apprehension about eroding confidence by American consumers and business and suggested that this alone could contribute to a double-dip recession, as a lack of confidence could curtail spending and lead the economy into a downward spiral.
While he doesn't expect a large decline in stocks - nor does he anticipate stellar returns - at the conclusion of our conversation, he expressed uncertainty about whether investors will be better off in stocks or bonds in the period ahead.
The positive case
Prof. Siegel uses a different method to value stocks and reaches a different conclusion - his analysis suggests stocks are undervalued by 30 per cent or more compared to long-term averages.
The biggest difference between his approach and Prof. Shiller's is that his is forward looking, focusing on consensus forecasts for operating earnings for this year and next. Among his criticisms of Prof. Shiller's methodology is that mega-writeoffs such as the $80-billion writedown by AIG will distort the earnings base from which backward-looking calculations are conducted for years to come.
Prof. Siegel has looked at U.S. stock market valuations over a 200-year period. During that time, stocks have traded at an average multiple of 15 times estimated earnings - by contrast, based on consensus forecasts for operating earnings, multiples for U.S. stocks come in at 13 times for this year and 11 times next year.
Furthermore, that average of 15 times earnings includes periods of double-digit inflation, when multiples are typically depressed. Excluding periods of double-digit inflation, the average multiple that the market paid for earnings was 17 times.
If earnings forecasts for next year are accurate, then returning to that long-term average of 15 times earnings would see stocks increase by 35 per cent. Rising to the historical low inflation valuation norm would see them go up by 50 per cent.
Prof. Siegel has plotted a long-term rising trend line in profit levels and stock market prices going back 200 years. When stock prices get above that trend line as they did in 2000, typically underperformance follows - and often prices drop below the trend line.
By contrast, when stock market prices are below the trend line as they are today, the lesson of history is that a period of out-performance follows.
In an industry where opinion often drowns out reason, Professors Shiller and Siegel stand out for their careful, fact-based approaches. Which view investors favour will largely depend on their going-in biases - those who are currently negative will look to Prof. Shiller's approach, those who are more optimistic will side with Prof. Siegel.
The good news is that these two views lay out clear parameters for the upside and downside case for stocks - and provide the foundation for a reasoned debate about the direction of stocks in the period ahead.
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