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The bull case on stocks

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Good morning. During the 2008 crisis, I was working in finance and, under the influence of good advice, sold stocks early on. In the short term this made me feel wonderfully clever. In the long term my self-satisfaction was expensive, because it took me years to get back into the market again. I have lost more money being overweight cash over the past decade than I saved by getting out of the way in 2008. Being bearish is a form of risk taking.

So today’s brief sermon encouraging bullishness, offsetting Friday’s case for bearishness, is for my own benefit as much as that of readers. 

The bull case on stocks

The best reason to own lots of stocks is always the same. It is this: 

That is the S&P 500 price for the last 150 years, on a log scale (the data comes from Robert Shiller at Yale). US equities have been an unbelievably powerful wealth machine, and you should have a lot of your money in them a lot of the time. Own stocks! 

Most investors, it must be said, do not have an investment horizon of 150 years. What bears are worried about, therefore, is periods like this:

That’s a 24-year round trip — not including dividends, but still. Here’s a more recent, 12-year round trip:

What is sickening about those two charts is that the first covers a period roughly equivalent to a normal person’s entire investment horizon; the second, about half of it. Even quite fortunate people only have, say, 25 years between the time when they have substantial assets to invest and the moment they retire. 

And it is legitimate to worry that 2021 is akin to 1929 or 2000, given valuations are uncomfortably near the 1929 and 2000 highs on some metrics, profit and economic growth are slowing, market leadership is getting thinner, and sentiment is turning. 

But we have to first make a distinction between the risk for the investor and risk for the person who manages investors’ money. Using Shiller’s data again, during that awful 1929 to 1954 round trip on price, investors’ real total return was 4 per cent annually (they clipped a nice dividend, in other words). That is an unspectacular but acceptable return, over the roughest quarter century in the market’s history, which included the depression and World War Two.

Dividends were not enough to provide a positive real return between the 2000 peak and early 2013, but if you bought at the 2000 peak — at the absolute worst time, in other words — and held on for 20 years, once again, you earned 4 per cent real annually. And those are the worst outcomes, remember. Buy stocks! Buy the dips, buy the peaks, but buy!

Things look slightly different, though, from the point of view of someone who works in money management. At some time point represented in the two charts above, they tend to get fired. This happened to me. Here’s the chart:

The professional risks of having your clients mostly in stocks heading into a bear market are real (though they are exceeded by the risk of having clients underweight stocks and then watching the market rise). So the possibility that we are on the cusp of a bear market requires attention.

The best argument against the notion that we are living in a 1929 or 2000 style period has a name. It is Tina (for “there is no alternative”). Here is a chart from Shiller, showing what he calls the “excess Cape yield,” that is, the cyclically adjusted real earnings yield on stocks, minus the real 10 year bond yield. It is a proxy for your expected returns on stocks, over and above the expected return on bonds. Shiller plots it against the subsequent 10-year return for stocks (the dotted green line):

The current excess yield on stocks does not scream “buy!” as it did, for example, in 2010 (when I was still psychologically frozen did not buy). But it does not shout “sell,” either. Similar levels of excess yield in the late 1980s, in 2008, and in 2011 were each followed by a decade of solid returns.

Tina is a real reason to stay with stocks. Low bond yields surely force many investors with target returns to buy stocks, and this must support stock prices. But it cannot be a sufficient reason. Consider, first, that rates are very low in Japan and Europe, too, but their stock markets have not had the smashing decade the US’s has. Second, remember that bull markets often end in panics, and in panics people do not sit around companying yields on various assets. They just want cash, immediately. 

So we need more reassurance than just excess yield on stocks. But there are three good sources of it:

  • Corporate profits are strong, and while their growth is slowing, it remains solid. Consensus estimates for S&P 500 earning growth in 2022 — after the pandemic effects have fallen out of the annual comparison — is 9.5 per cent, according to FactSet (and do you know what high profits fund? Buybacks).

  • GDP growth, similarly, is slowing but is still above trend. For the current quarter, according to the Atlanta Fed’s GDPNow real-time estimate, output is growing at 3.6 per cent. The estimate was for six per cent just a month or so ago, and one likes a slowdown, but if the Delta variant subsides, supply bottlenecks continue to clear, and more fiscal support is rolled out, growth could reaccelerate nicely next year. Five (ish) per cent growth in 2022 is not out of the question. 

  • The Fed is clearly determined to keep rates low until they see the whites of non-transitory inflation’s eyes. 

Given all this, and against the background of Tina, is it really time to take US equity risk off the table?

All bets are off, of course, if inflation gets out of control and the Fed has to push the economy into recession to stop it. Whether the above bull case convinces you will depend on the probability you place on that happening. But if you are sanguine about inflation, a little deceleration from abnormally high growth levels, and the accompanying shift in sentiment, seem like bad reasons to underweight the best asset class there ever was. 

One good read

Forty concepts you should know (hat tip to Tyler Cowen for the pointer).

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