S&P500 dropping to 600 by spring 07

[(former)FormerSanDiegan]

Did any of you foresee the pop of the NASDAQ bubble back in ’00? Or the fall of the S&P 500, then, too?

I began liquidating stocks in March -April 2000 in order to generate a down payment to buy a second house. SO, yes, I did. Of course it was mostly luck as I didn’t see stocks falling as much as they did.

That said, I’ve always kept a healthy chunk of my investments in stocks (between 50-80%) primarily in index funds. It has worked out OK. I have trimmed it down to ~65% over the last 12 months (unfortunately, at least in the near term).

Stocks are not nearly as overvalued as some here are led to believe. P/E ratios in the 17-20 range for S&P 500 in a 5-6% interest rate environment is nearly properly valued IMO. That is based on fundamentals, not psychology.

Sure stocks are vulnerable to a slow-down in the economy and could easily fall by 20% should we hit recession. But, in general stocks are not as overvalued as housing was in 2005.

[davelj]

“Did any of you foresee the pop of the NASDAQ bubble back in ’00? Or the fall of the S&P 500, then, too?”

At the time I was a sell-side analyst. I wrote a research piece saying a decline of at least 60% was in order; that is, 4914 (price at the time I wrote the report) to less than 2000. My firm’s clients thought I was nuts. It actually declined further than that.

Bubbles aren’t hard to identify. They’re hard to resist and to time.

The role of the market, after all, is to get people bullish at the top, bearish at the bottom and confused in between. (I forgot who originally said that.)

[Anonymous]

FSD, what have you indexed since ’00? S&P 500 and Russell 2000, 50%/50%, like I did until 2 1/2 years ago? S&P has been dead flat since ’00. Russell is up 60% since ’00. 50% at 0% + 50% at 60% over six years = 6% per year. How can you call that “…worked out OK…”? 6% okay? Up your standards, sir.

And, liquidating a portion of the portfolio to fund a downpayment on a second home is not foreseeing a bubble, moving out everything, and watching the carnage from the sideline.

It’s kind of like me saying that, yes, I missed the upcoming ’06-’10 housing crash (without adding ‘because I lost my job in ’03 and had to sell my McMansion’).

Forthrightness, FSD.

davelj, great call back in ’00. I wish I had lost my blind belief in indexing back then. But, at least I lost it in time to enjoy a nice ride up in gold mining stocks over ’05-’06.

[(former)FormerSanDiegan]

jg –

And, liquidating a portion of the portfolio to fund a downpayment on a second home is not foreseeing a bubble, moving out everything, and watching the carnage from the sideline.

It’s kind of like me saying that, yes, I missed the upcoming ’06-’10 housing crash (without adding ‘because I lost my job in ’03 and had to sell my McMansion’).

Forthrightness, FSD.

I did not liquidate and sit on the sidelines in 2000. I simply moved my funds to what I thought would be a better investment based on the relative valuation of stocks and rental real estate. What’s wrong with that ?

That said, the funds liquidated were only my non-retirement assets. My retirement accounts stayed primarily (but not close to 100%) in stocks.

I believe in porfolio balance, not putting eggs in a single basket, but that’s just me. Probably too conservative.

[davelj]

“Stocks are not nearly as overvalued as some here are led to believe. P/E ratios in the 17-20 range for S&P 500 in a 5-6% interest rate environment is nearly properly valued IMO. That is based on fundamentals, not psychology.”
– FormerSanDiegan

I don’t mean to pick on you FSD, but you’re making two dangerous (albeit common) assumptions: (1) that the “E” in the P/E is “normal,” and (2) that interest rates will remain constant over the average investor’s investment horizon.

Where the “E” – earnings – is concerned, corporate profitability is at an all-time high. Unfortunately for those long stocks, corporate profitability is one of the most consistenly mean-reverting time series in all of financial history. (As Jeremy Grantham likes to correctly point out, “If profitability doesn’t mean revert over time then capitalism is broken.”) So when the “E” reverts to historical norms during and after the next recession there could be a large valuation adjustment on that count alone.

The other issue is that long-term interest rates have been known to rise from time to time, recent history notwithstanding. Change that 6% long term rate to just 7% and all of a sudden you’ve got another valuation adjustment to consider.

Finally, EVEN IF margins remain high for some time AND rates don’t increase, the S&P is only priced to return about 6%-7% annually over the next 5-10 years (that’s 1% dividend yield + 5%-6% earnings growth). Why buy stocks to return 6%-7% when you can buy a CD and earn 5.5% and take virtually no principal or duration risk? Yes, there’s a tax differential for many folks, but you see the point. You’re just not getting compensated to take stock market risk these days, so why take it? Why indeed…

[(former)FormerSanDiegan]

FSD, what have you indexed since ’00? S&P 500 and Russell 2000, 50%/50%, like I did until 2 1/2 years ago? S&P has been dead flat since ’00. Russell is up 60% since ’00. 50% at 0% + 50% at 60% over six years = 6% per year. How can you call that “…worked out OK…”? 6% okay? Up your standards, sir.

Yes, I will take that 6% per year in a period that included an 80% decline in some tech stocks, a recession, a terrorist attack on US soil, two wars, the worst stock market performance in a a couple generations, and a period in which cash paid about 2% up until the last 2 years.

Yes, I’d call 6% per year working out OK.

TO answer your quesiton :
I have used SPY (S&P500) and VTI (Wilshire 5000) as my primary stock holdings since 2000. However, I don’t blindly index. These make up the primary portion of my stock holdings, but not all of them. I occasionally buy stocks, funds, and ETFS, including international (e.g. EFA, EWJ) to balance risk and move to/from cash on occasion.

For example, today S&P 500 and Wilshire make up about 35% of my total (over half of my stock allocation). In 2004, these indexes accounted for 45% of my portfolio, which was ~80% stocks.

[(former)FormerSanDiegan]

davelj –

I did not say that stocks were cheap, particularly at this stage of the economic cycle. But they are not as overvalued as the uber-bears lead us to believe. Earnings growth dropping below 10% in the first quarter (down from double digits) and potentially dropping further and potential rise in interest rates are definitely concerns.

I would not be surprised with a 10-20% decline in stocks sometime in the next 12 months.

If one is expecting interest rates as high as the late 70’s/ early 1980’s, then I’d definitely shy from stocks.
I don’t expect that.

Now, about that risk premium. How does your current assessment of a risk premium of 1.5% compare to history ?

Below is a chart showing the S&P 500 P/E and inverse yield on the 10-year bond.
There are definitely periods (e.g. before 1964) where a risk premium appears, but it tends to be small or non-existent most of the time.
1974 – 1980 was the only period I can find where the risk premium re-appeared after 1964.

EDIT: Today 100/10-year yield is 21.4.

[img_assist|nid=3322|title=Stock Market P/E and Inverse Rates|desc=|link=node|align=left|width=466|height=315]

[Coronita]

I really hope no one took this person seriously back in august and bought reverse indexes….

[(former)FormerSanDiegan]

f_l_u –

Of course we didn’t. The primary post was discounted by many at the outset. Recently, this has become the most convenient place to post ramblings about where stocks might be headed … or not.

[Anonymous]

Ah, typical day in the ‘new stock market’: weak job growth in April, job growth in February and March revised downward, creeping up of the unemployment rate.

Upward goes the market. Hilarious.

[Coronita]

I’m not complaining. Markets are irrational. Actually, you want to make a quick buck, buy a lot of july/august put options on Yahoo.

See it today? Typical Buy on Rumor, Sell on news.
This MSFT merger rumor I doubt will happen.

[HereWeGo]

Actually there were a large number of puts bought on DJ yesterday. I guess folks think Rupert might withdraw his offer.

[an]

There’s also rumor about Google putting in a bid for DJ.

[poorgradstudent]

jg wrote: “Ah, typical day in the ‘new stock market’: weak job growth in April, job growth in February and March revised downward, creeping up of the unemployment rate.
Upward goes the market. Hilarious.”

You know, I’m no where near as bearish as you are, but I agree that right now the market seems to have a lot of “panic buying” that doesn’t pay much mind fo the data.

That said, earnings have been strong this quarter overall. Their sustainability is questionable, but earnings and mergers are a big art of what has been fueling the beast.

[davelj]

“Now, about that risk premium. How does your current assessment of a risk premium of 1.5% compare to history?”
– FSD

This is a good question, FSD, and gets to the heart of the matter. Long story short, since 1926, the 3-month treasury bill has averaged around 3%, the 10-year treasury around 6%, and stocks have returned around 11%.

So, historically – “historically” being the operative word – the risk premium for stocks over short-term treasuries has been around 8%/year and over long-term treasuries about 5% per year.

The question is what SHOULD the risk premium be. After all, at 1926, the typical starting point for a lot of the long-term studies, stocks were “cheap” by today’s standards. Consequently, the long-term historical returns are skewed by this fact (although this skewness declines each year). Pick a different starting point – say 1968 – and you’ll get a much smaller risk premium because stocks were more expensive. Many researchers have suggested that the long-term risk premium realized by stock investors was too high with hindsight and suggest that the “real” risk premium over the 10-year treasury “should” be around 3.0%-3.5% based on relative risk and volatility under a “rational expectations” framework. I agree with this approach.

So, here’s my opinion. 30-day treasuries should yield about the rate of inflation over the long term (you shouldn’t get much a premium over inflation for taking no risk); let’s use 3% inflation just for argument’s sake. The 10-year treasury should yield some premium over short-term treasuries due to duration risk. In my view, this number should also be around 3% – that’s what it has been historically. In other words, historically investors have said, “If I’m going to invest for 10 years I want a 3%/year return premium for doing so because I don’t know what’s going to happen in the interim.” I think that’s a rational expectation.

Likewise, I think it’s rational to expect to earn another 3% per year over the 10-year treasury for taking on stock market risk. Again, these numbers aren’t exact (obviously), but they’re good ballpark numbers in my view based on what I think a reasonable person should expect given the relative risks involved.

Clearly the risk premium shrinks and expands over time based on participants’ appetite for risk and judgements about the future. But I think the 3%/6%/9% (approximate) framework is what we’ll see over the very long term as a mean-reverting series. Why? Because in the absence of some other, more logical view, it just makes sense.

So, the problem right now is that I think the current high margins will mean revert over the next couple of years AND the risk premium will expand to 3% (or so). The combination of these things means stocks are likely headed down. Whether that’s 20% or 40% I don’t know. But it’s going to be a surprise to most folks and it’s going to hurt. That’s how markets work.

[One other thing: the chart you posted is essentially the so-called “Fed Model,” which has been thoroughly discredited as a tool for equity valuation from both theoretical and empirical standpoints. Google “problems with fed model” and you can read about the model’s shortcomings, which are many and varied.)

[Author]

Posts