Recently, many people have been denouncing buy-and-hold investing. Among phrases heard: “long term investment died as a thesis” this year. Of course, these voices are featured most prominently after a huge fall in the market, when the outlook for returns from long term investments has actually improved.
The best example of this is a Business Week front-page story titled “The Death of Equities,” published in August of 1979. Then, as now, investors were weary of a long, painful bear market. The story didn’t mark an exact bottom in the market, however in the two decades that followed the S&P 500 increased more than tenfold.
Valuations finally looking good
Robert Shiller, in his perfectly timed Irrational Exuberance, (published in March 2000) made a strong case for stocks being wildly overvalued. That was a good time to question the wisdom of buying and holding stocks regardless of valuations. Shiller used a chart of P/E ratios that tracks a 10-year moving average for earnings to dampen the effect of earnings fluctuations on P/E ratios. At the time Shiller’s book was published, this adjusted P/E ratio was a record 43. This methodology of tracking the market has since been popular and is updated on Shiller’s web site.
As Shiller’s data has a lag of a couple of months, I decided to update his graph with the recent market action. By this measure, the market is cheaper than it has been since 1985. Rather than questioning stocks as viable investment vehicles, it seems to me that stocks are looking better than they have looked in over twenty years.
Earnings cycles
Many investors have raised doubts about P/E ratios as earnings have been unusually high in recent years, but now it seems clear they are destined to fall in coming years. When this happens, they say, the P/E ratio will rise again. The graph below shows earnings as a share of GDP since 1948. The earnings numbers are based on data from the Bureau of Economic Analysis (BEA), which is designed to be consistent over time and excludes capital gains and losses, for instance. We can see that corporate profits were a relatively small component of GDP in the 70s and 80s, with a fair amount of time being spent in the 6% – 8% range. Recently, corporate profits have fallen from a peak of 12.9% of GDP in the third quarter of 2006 to 10.2% in last quarter. It is not hard to imagine profits falling further. How far this fall will be is anyone’s guess, but barring a Marxist revolution or a complete breakdown of the U.S. economy, 6% seems like a reasonable floor.
An earnings history for the last sixty years (from the same BEA data set as above) shows that overall corporate profits (shown here on a logarithmic scale) are not all that volatile. Besides, the value of stocks represents claims on their future earnings into perpetuity, so one very bad year should have a limited impact on valuations.
No reason to shy away from the market
The extreme volatility that has been prevalent in the market in recent months is disconcerting for those hoping to turn a quick profit on their stock purchases, but should not cause long-term investors much alarm. As discussed above, stocks are cheaper than they have been for decades. What makes the market even more attractive now is that interest rates are low, in stark contrast to the very high rates of the 1980s. Far from being dead, the buy and hold investment approach is in good health.
