Recently, Professor Jeremy J. Siegel of Wharton School of the University of Pennsylvania spoke on the outlook for stocks and bonds returns at the conference on 18 Nov 2015.
The following is a summary of the presentation:
Since 1802, the US stock returns was 6.7% per annum in real return (i.e. after adjusting for inflation). For Gold it was 0.5% per annum and the dollar was -1.4% per annum (i.e. lost money). However, from 2000 to 2015, the real return for US stocks was 2.9% per annum.
The US stock returns is not the highest in the world. Based on 115 years of data, the highest stock returns comes from South Africa and followed by Australia. The US stock returns came in third.
What is interesting is that the equity risk premium throughout the world is almost the same. The equity risk premium (i.e. the additional stock returns compared to bonds) have been large and stable across many countries.
He then turns to talk about PE ratio.
Based on 1954-2015, the median PE for S&P is 16.7. When interest was less than 8%, the average PE is 19. With reference to 10-year CAPE ratio developed by Professor Robert Shiller of Yale University, the median PE 15.87 for 1871-2014. Average PE is 15. Interestingly, the earning yield which is the reciprocal of PE is = 1/15 = 6.7%. That is why 6.7% is the real return for stocks on the long-run.
He now change his focus for the short term. The S&P 500 current operating earnings is 6% lower than 2014 due to strong dollar, lower oil prices. However, stocks are selling 18.9x 2015's earnings, but only 16x 2016 earnings. Taking the average two PEs is 17.5x and this is equivalent earning yields of 5.7% real return for stocks. That is 5% over bonds (equity risk premium). The historical average is 3% to 3.5% for equity risk premium.
The high equity risk premium of 5% vs the historical average of 3% to 3.5% is likely to remain for long-term. The following are the reasons:
The ten-years TIPS yield have dropped significantly over the years. It was negative in 2012 and currently 0%. Reasons for such low yield is due to lower forecast GDP growth at about 2% or less over next 10 years, increased risk aversion of aging investors, desire for liquidity, demands for bonds by pension funds. That is why the risk premium is 5% instead of the historical 3.5%. Professor Siegel thinks the low interest rate will be permanent. Fed fund target rate is likely 2% (the new rate) instead long-term of 3%. Permanently lower interest rates impact prices of all assets.
Professor Siegel is of view that it will do the economy good to have the Fed rate increase by 25bps. After the increase in Fed rate, value & dividend stocks could do well because few advisers want to position their clients into yield-oriented stocks now in view of the policy uncertainty.
Professor Jeremy J. Siegel turns his focus on CAPE.
The Shiller's CAPE PE is 26.19 at the end Dec 2014. The predicted stock return using the model is 2%. However, 404 out of 410 years from 1981-2014, the actual real return exceeded forecasts using CAPE model. Since 1991, there have been only 9 months when CAPE ratio has been below its mean. It seems the CAPE model is too bearish. Most of the poor return on equities is due from the return of the ratio from the average. Professor Jeremy J. Siegel thinks that the reason why the CAPE is too bearish is because the reported earnings definition have changed to mark-to-market in recent years. These days, such impaired assets cannot be mark up unless it is sold. This means the 'earnings' have been unestimated. Professor Jeremy J. Siegel made adjustment to the CAPE in his research paper to take account of the change of this accounting change and his newly adjusted CAPE show that the CAPE is only slightly overvalued.
Finally he spoke about the calculation of GDP. He felt that the calculation of GDP may not be accurate these days because of lot of ‘free service’ from the digital gadgets are not captured by the GDP calculation.
You can view the entire video below. The presentation is technical but it is worth viewing:
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