Stocks Now Distinctly Cheap

One of the only silver linings of the current mess is that stocks are increasingly priced to deliver a compelling long-term return.  Given that stocks had been overvalued for more than 15 years through last summer, this is a refreshing change.  If the S&P does go to 600, which we think is possible, stocks will finally be a screaming buy.

Here are GMO’s 7-year forecasts as of December 31, 2008. The S&P is down another 9% from there.


GMO bases its forecasts on cyclically adjusted earnings, the same methodology used by professor Shiller in the chart below.  (The “E” in a cyclically adjusted P/E is an average of the last 10 years of earnings. This mutes the impact of the business cycle, which can produce single year P/Es that are very misleading). 


Prof Shiller’s work shows clearly that stock values are mean-reverting.  The only trouble is the time they take to mean-revert.  If things go badly over the next few years, stocks could bounce along the bottom for another decade or more.

For example, Jeremy Grantham, whose shop produced the forecasts above, reminds us what happened in the 1970s:

Today all equities are moderately – one might say, boringly – cheap.  The forecast for the S&P has been jumping around +6% to +7% real, with other global equities slightly higher. 

To put that in perspective, a 1-year forecast done on the same basis we use today that started in December 1974 would have predicted a 14% return (which, by the way, it did not deliver since the market stayed so cheap).  For August 1982, the forecast would have been shockingly high – over 20% real!  So do not think for a second that this is as low as markets can get. 

(It’s worth noting, though, that 1982 was the start of the great bull market.  Jeremy also warns of the possibility of another sucker’s rally, so don’t get too comfortable waiting for the bottom:

Now, I admit that Greenspan and 9/11 tax cuts caused the “greatest sucker rally in history” from 2002-07.  We therefore cannot rule out another aberrant phase in which extreme stimulus causes the market to rally once again to an overpriced level for a few more years, thus postponing the opportunity to make excellent long-term investments yet again.  But I think it’s unlikely. )

One thing seems certain: Stocks are cheaper now than they have been at any time in the past two decades.  That’s encouraging for those with another couple of decades to invest and–increasingly rare these days–cash to put to work.