As frustrating as the current environment is, we believe the US market merits a much higher valuation level than it is currently being accorded.
Unless the US economy slips back into recession – a scenario we view as quite unlikely – and corporate earnings turn down, we would expect the market to be meaningfully higher than it is now in the next six months to one year.
Former Federal Reserve governor Lyle Gramley, an economist whose work we greatly admire, puts the odds of a double-dip recession at about 10% to 20%, while work by two researchers at the Cleveland Fed, Joseph Haubrich and Kent Cherny, put the odds of a double-dip at about 12%, the low end of Gramley’s range.
If the economy avoids recession and continues to recover, even if haltingly, earnings should continue to rise as well. According to Standard & Poor’s, consensus earnings estimates for the S&P 500 Index for this year and next put the Index at about 12.6x 2010 estimates and about 10.9x 2011 consensus estimates based on recent market levels.
But if stocks are so attractive, why then are they not generating more enthusiasm among investors?
We think the answer is simply that investors’ experience with equities over the last 10 years has been so painful that they have lost faith in stocks as long-term wealth builders. They have recently been putting their trust in asset classes which have treated them better, notably cash, Treasury securities and, to a lesser extent, gold.
But taking a much longer term view, the appeal of stocks as superior wealth builders should become more apparent. In Jeremy Siegel’s book, The Future for Investors, total real returns for five assets – stocks, bonds, Treasury bills, gold and the US dollar – are presented from 1802 to 2003.
When the figures are updated up to 2009, the results, showing the inflation-adjusted value of one dollar invested in each asset in 1802 with income reinvested, demonstrate stocks to be the very clear winner.
So why do equities significantly outperform other financial assets over long periods of time? We actually think the answer is fairly simple. Stocks represent ownership interests in businesses.
Over time, businesses have the ability to adapt and adjust to changing economic circumstances. Some succeed grandly; others fail miserably.
But as a group, they have the ability to evolve, thus giving them the capacity to deliver returns that other financial instruments – whose terms are largely fixed – cannot match.
To secure that advantage, equity owners must bear greater risk of short-term loss and higher volatility. Given the magnitude of the difference in returns over time, that strikes us as a risk worth taking.
David Nelson is chairman of the investment policy committee at Legg Mason affiliate, Legg Mason Capital Management
