Monday Morning: Taking the bull by the horns, sort of

On Sept. 21, I increased my equity exposure in our company’s profit sharing plan by 5 percentage points. I believed that the market had once again overreacted to bad news, as it has done so often in the past. But I was feeling somewhat lonely as the market continued to tumble last Monday.

By chance, Rob Arnott, managing partner of First Quadrant, a money management firm that specializes in tactical asset allocation and other quantitatively based investment strategies, called me last Tuesday and expressed the view that the market had been hit too hard by the disaster.

In the short run, that means there is a buying opportunity. But Mr. Arnott believes that on a long-term basis, the market is in fact still very expensive. That is, it is still overpriced.

His call was prompted by the comments of an investment strategist who pointed out that if the tech sector stocks are removed from the Standard & Poor’s 500 stock index, the price-earnings ratio of the S&P is only 16, close to the historic average p/e.

Mr. Arnott’s response was that if you remove the highest-priced stocks from the index, and the average p/e falls only to the historic average, then the market as a whole is still pretty expensive.

If the market had been less expensive when the events of Sept. 11 occurred, he says, the impact on the market would have been less dramatic.

exaggerated

Embedded in the current level of the market is an exaggerated expectation for the growth of corporate earnings, Mr. Arnott believes. The market is assuming that real corporate earnings can grow at 5% to 7% a year, he says. That can be seen constantly in analysts’ reports.

But real gross domestic product growth has historically been only 2.5% to 3% per year, and real earnings growth can’t be greater than that for any extended period, Mr. Arnott says. Earnings growth has historically been 1% to 2% per year.

If investors are content to receive returns from stocks equal to those they can get from bonds, then they can invest in stocks for the longer term. But if investors expect to achieve higher returns than bonds yield, the stocks have to be a good deal less expensive.

On Sept. 26, The Wall Street Journal published an article by Burton Malkiel arguing that the stock market, after losing more than $1 trillion in the wake of the attack on the World Trade Center, is now reasonably priced.

Mr. Malkiel, a professor of economics at Princeton University, is also the author of “A Random Walk Down Wall Street,” one of the seminal books on the stock market. In the book, he argues that the market is efficient, and attempts to outperform it are a waste of time.

Mr. Malkiel’s article concludes that, based on historic relationships, current bond yields and the rate of inflation, the market p/e should be about 22. In fact, based on current estimates of corporate earnings, it is in the low 20s.

Because that is well above the historical average of about 15, Mr. Malkiel writes, many commentators have expressed concern that the market is overpriced, and further declines are likely. He disagrees, saying it could move up from here.

Both of those views are comforting for me in the short run. I had had a fairly low equity exposure, only 40%, because I believed that the market had moved far ahead of where it should have been, based on the record high market p/e’s of 1999. After the new commitment, it’s still fairly low but probably appropriate for my age and risk tolerance.

If Mr. Malkiel is right, I will share some of any market gains. If Mr. Arnott is right, and the market underperforms on a risk-adjusted basis for the next several years, my retirement plans won’t be too badly hurt.

In the meantime, I can still sleep nights without worrying about my investments. That’s probably a key ingredient for any investment program.

Mike Clowes is the editorial director of InvestmentNews.