When I was a child a person could store cash in the bank and get paid seven, eight even ten percent for doing so. With interest rates like that, there wasn’t much motivation for people to buy stocks.
It isn’t surprising then to find out that in the early 1980s when interest rates were extremely high, stock valuations were extremely low.
When it comes to stock valuations interest rates matter!
The chart below shows the trailing twelve month S&P 500 PE ratio or price-to-earnings ratio back to 1926. You can clearly see the low price-to earnings ratio of the market that existed in the early 1980s.
Not surprisingly, when nobody wanted to buy stocks (or bonds for that matter) in the early 1980s was exactly when people should have been buying stocks (and bonds).
Of course it is easy for me to sit here today and say that locking in 1980s interest rates was an easy decision and that buying stocks at low price to earnings ratios was too. I don’t have inflation skyrocketing all around me like investors did back then, so today with the benefit of hindsight it feels like a no-brainer.
How about then I step to the plate and make a forward looking observation instead?
I think that today is a lousy time to be investing in the S&P 500. Investors buying an index fund (SPY) today are going to do very poorly over the next 5 or 10 years. Valuation multiples are high and interest rates can’t really be much lower so we can’t on a tailwind there going forward.
I’m not saying negative returns over ten years, although I believe that is possible. But I do think that sub five percent is possible from the current level.
Now I will also say that I believe that it isn’t all stocks that are expensive. My belief (and I base that based on the opinions of the world’s top investors which we gather at the Superinvestor Bulletin) is that there is indeed a passive investing bubble that has inflated the largest constituents of the S&P 500.
The market is very expensive, but the market is dominated by a few stocks.
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Allen Gilmer, Co-Founder and Executive Chairman at DrillingInfo, Inc., is not a man who minces words, an attribute that has served him well during a long career in the oil and gas industry. When it comes to the Permian Basin and the amount of oil and gas resource contained in it, he becomes positively loquacious.
“We should view the Permian Basin as a permanent resource,” he says, “The Permian is best viewed as a near infinite resource – we will never produce the last drop of economic oil from the Basin.”
No one disputes that the resource in the Permian is huge, but ‘infinite’ is a big word. I asked him to expand on that concept. “That is the practical reality with the amount of resource that is in the ground,” he says, “The research we’ve done indicates that we have at least half a trillion barrels in the Permian at reasonable economics, and it could be as high as 2 trillion barrels. That is, as a practical matter, an infinite amount of resource, and it is something that has huge geopolitical consequence for the United States, in a very good way. It has a huge consequence in terms of GDP, and right now it is creating an American energy global ascendancy.”
“You can flip a coin to change its face, but it remains the same coin.”
The battle is on. In the bulls’ camp, enthusiasm is rising. Global economic growth is accelerating; yet inflation is modest – in many countries almost non-existing. Inflation-less economic growth, they call it. On the other side of the table you’ll find a sizeable camp of bears. It is all going to end in tears, they argue. No wonder the average investor is slightly puzzled. What on earth is going on?
One side of the coin – the bull case
The return on US equities since 2009, when the current bull run was first established, has been quite extraordinary – almost 300% to be more precise (Exhibit 1), and the current equity bull run shows few signs of coming to an end.
In defence of the bull case, one has to admit that the current level of investor optimism is more than just wishful thinking. Consumer confidence is growing, and so is business confidence, both of which are powerful drivers of equity returns. The global consumer is now more confident than he has been at any point since the 2007-08 upheaval (Exhibit 2).
The bulls take great comfort from the fact that the global economic recovery appears to be intact, even if the outlook for the second half of the year is modestly softer than the solid growth most countries enjoyed in the first half. Uncertainties surrounding US economic policy under Trump’s stewardship combined with slowing economic growth in China are the two main reasons why global GDP growth is likely to modestly slow in H2.