So far, the bulls have listened, paused, and then trampled the warnings.
I refer the fact that two big guns of the investment world, fabled Warren Buffett of Berkshire Hathaway and Morgan Stanley investment strategist Barton Biggs, have publicly declared this a dangerous and overvalued stock market.
Why? How?
Let’s start with a careful dissection of stock market returns, presided over by none other than Jack Bogle, the crusty founder and chairman of the Vanguard Group. While Mr. Bogle likes to joke that he has “had a change of heart” about a lot of things since his heart transplant, he still believes that stock market returns come from three sources: dividends, rising corporate earnings, and changes in what investors will pay for those earnings.
In early 1991, speaking about possible stock returns for the 90s, Mr. Bogle put out three possible cases:
- a “Best” case in which earnings were strong and P/E multiples rose somewhat;
- a “Worst” case in which P/E multiples declined to slightly below their long term average and earnings growth declined;
- and a “Most Likely” case in which earnings growth was above average but P/E multiples declined to their long term average of 14.
Possible Stock Returns For the Nineties
| Return Source | Best Case | Worst Case | Most Likely |
| Entry Yield | 3% | 3% | 3% |
| Earnings Growth | 10% | 4% | 9% |
| P/E change | 2% (1) | -2%(2) | -1%(3) |
| Total | 15% | 5% | 11% |
- assumes final P/E of 18
- assumes final P/E of 12
- assumes final P/E of 14
Source: Vanguard
As you can see, Bogles’ Best Case, a 15 percent annual return, has prevailed: stocks in the Standard and Poors’ 500 Index are now yielding 1.8 percent and selling at 20 times trailing earnings.
Now let’s do a replay of the same analysis with current figures. Our calculations, like Mr. Bogles’, assume that P/E multiples change over a ten year period. The seven percent figure in the “most likely” case is the long term average rate of corporate reinvestment.
Stock Returns for the Next 10 Years, Re-examined
| Return Source | Best Case | Worst Case | Regress to Average | Low Inflation |
| Entry Yield | 1.8% | 1.8% | 1.8% | 1.8% |
| Earnings Growth | 10.0% | 4.0% | 7.0% | 7.0% |
| P/E change | 0.0% (1) | -5.0%(2) | -3.5%(3) | -1.0%(4) |
| Total | 11.8% | 0.8% | 5.3% | 7.8% |
- assumes final P/E of 20, unchanged
- assumes final P/E of 12
- assumes final P/E of 14
- assumes final P/E of 18
Source: Author calculations
To find out the odds on earnings multiples, I called the Leuthold Group in Minneapolis, an investment strategy firm well known for its investment benchmarking. I asked what percentage of the time, since 1926, had stocks had sold at various P/E multiples?
The answer: stocks have sold at 14 times normalized earnings or better 50.7 percent of the time; at 16 times normalized earnings or better 39.4 percent of the time; at 18 times normalized earnings 21.1 percent of the time; and only 5.6 percent of the time at 20 times normalized earnings or better. Periods of low inflation tend to have higher than average earnings multiples. While we have to pay some attention to the difference between “trailing” earnings and “normalized” earnings because the latter smoothes earnings over a 5 year period, the figures tell us that banking on stocks selling at 20 times earnings— the current multiple— is a real long shot.
Bottom line? The unimaginable is happening: the returns on cash and bonds are starting to look competitive with common stocks.
If P/E multiples decline to their long term norm of 14 over the next ten years, the total return on common stocks would be about 5.3 percent… the current yield on money market funds and short term Treasuries.
If they merely regress toward a low inflation multiple of 18, the total return projects to only 7.8 percent a year, about equal to the current 7.75 percent yield on high quality 10 year corporate bonds according to Merrill Lynchs’ index.
The fat lady, dressed in interest rate fears, may be about to sing.
Readers who would like to read Mr. Buffetts’ comments directly should go to the Chairman’s letter and “owners manual” in the 1996 annual report for Berkshire Hathaway. It is located on the World Wide Web at: “www.berkshirehathaway.com”
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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(c) A.M. Universal, 1997