Morgan Stanley
  • Wealth Management
  • Jan 23, 2017

Should Investors Party Like It’s 1999?

With markets displaying a number of similarities to the late 1990s, can investors expect the same kind of blow-off rally to close out the eight-year-old cyclical bull market?

Have markets come too far too fast? Or should investors stay at the party a while longer?

Investor angst about markets having run too far too fast is predicated on many concerns, the most common of which is valuation. With the strong rally in stocks and sell-off in bonds, many investors and strategists are now asking if markets have become overvalued. The consensus view is that stocks have become expensive and therefore the next correction could be quite meaningful—possibly 10% or 20%.

Our view at the Global Investment Committee—Morgan Stanley’s group of seasoned investment professionals who meet regularly to discuss the global economy and markets—is that U.S. stocks remain fairly priced at worst and downright cheap in the context of such low interest rates. Outside the U.S., stocks are even cheaper given investors’ less optimistic view about growth and/or political concerns in many of these regions.

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Not All Metrics Are Created Equal

One of the problems with valuation metrics is that there are so many of them and everyone has their favorite. Our metric at the Global Investment Committee is simply the consensus bottom-up 12-month forward earnings estimate divided by the average corporate borrowing rate, for which we use Moody’s Baa yield. Right now that sets our “fair value” measure for the S&P 500 today at 2,833.


Our Fair Value Model Shows S&P 500 to Be Undervalued

* Estimated earnings per share divided by Moody’s Baa bond yield
Source: Bloomberg as of 1/13/2017

We focus on the fair value measure described above because it incorporates both earnings and interest rates while many traditional measures ignore interest rates altogether. We think such an omission is fundamentally flawed as lower interest rates can and should have a dramatic effect on valuations.

More importantly, we think the relationship shown in the chart above illustrates that such a measure has done a good job of keeping investors informed about valuation over time. First, it clearly identified the overvaluation in the 1990s for which investors ultimately paid dearly in 2001 and 2002. Second, it did a very good job of explaining why stocks collapsed so badly in 2008 and 2009— earnings forecasts collapsed and corporate borrowing rates rose significantly.

Finally, the chart does a great job of illustrating just how much the financial crisis scarred investors’ psyches and strongly suggests we have yet to reach an excessive level of optimism, or euphoria, during this cyclical bull market. In other words, euphoria is yet to come and we think that period is just beginning.

Predicting "Irrational Exuberance"

Another very good and popular valuation metric is the cyclically adjusted price earnings ratio (CAPE). It’s also known as the “Shiller P/E” after its creator, Nobel laureate and Yale University economist Robert Shiller. Understanding that earnings are highly cyclical due to economic expansions and recessions, the Shiller P/E essentially normalizes earnings by taking the 10-year average historical earnings for the denominator rather than using a single point estimate.

What Shiller discovered is that this measure does not tell us much about the near-term valuation of the broader stock market but in the long term it is exceptionally accurate as you can see below.


Cyclically Adjusted P/E Indicates Modest Gain Ahead for U.S. Stocks

*Cyclically adjusted price/earnings ratio or “Shiller P/E”
Source: Bloomberg, Robert Shiller as of Dec. 30, 2016

In short, the current Shiller P/E has been an uncanny predictor of the 10-year forward compounded annual returns of the stock market. This adds credence to the claim that in the end, valuations are your best margin of safety when investing. Buy a good asset at a good price and you will make a solid return over the long run. Of course the corollary holds as well—don’t overpay or you will be sorry.

Never was this mantra more true than the late 1990s. Obviously, the Shiller P/E was abnormally high in that period and though investors did well in the short term while ignoring these warnings, they ultimately paid the price when the tech bubble burst in 2001 and 2002.

With the Shiller P/E approaching higher levels, many investors have worried about getting fooled again. However, we are still well below the levels reached in the late 1990s and at current levels the Shiller P/E is telling us to expect lower, but not negative returns in the next 10 years. With interest rates so low, that means stocks still look relatively attractive.

While the Shiller P/E has not proven to be a good market timer, we found that we could accurately project near-term prices by using the Shiller P/E from 10 years ago (see below).


Shiller P/E Model Tells Us to Remain Fully Invested in Stocks

Source: Bloomberg, Robert Shiller as of Dec. 30, 2016

The Shiller P/E would have correctly kept you fully invested in U.S. stocks during this entire cyclical bull market. And, it’s still telling us to remain fully invested despite its above-average reading. That’s because next year’s price is based on what the metric was saying back in 2007 and 2008, not what it is saying today.

Specifically, the Shiller methodology is projecting a fairly steep acceleration in the S&P 500 during the next 18 months. It gives us an upside target of 2,778 on the S&P, coincidentally the same target suggested by our fair value model. In other words, both our S&P 500 fair value method and the Shiller P/E support significantly higher equity prices.

Note: This article first appeared in the January 2016 edition of “Positioning,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.

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