Brad DeLong is relatively optimistic on stock returns

There are many interesting charts and graphs in the post, and he argues against a belief in mean reversion, along with a discussion of “the original Black Swan.”  It is a difficult post to excerpt, best to read and view the whole thing.


This is an incomprehensible sentence and certainly not consistent with how the rest of the world interprets the efficient market hypothesis:

"An extremely naive take would be to assume the efficient market hypothesis: that the marginal trader and the marginal firm know what they are doing, and that the margin the earnings of the companies in the index are equally valuable if paid out or if reinvested."

There is a sensible interpretation of what DeLong does in the subsequent graph, but it's not just assuming efficient market hypothesis.

It may not be a standard definition, but it works. If the marginal traders set the price then why would they sell a share of stock rather than take the accumulated earnings, and vice versa for the guy on the other side of the trade. The price must reflect the expected discounted present value of earnings, which in turn will compound all available knowledge.

The vast majority of them have no choice whatsoever. Think pension funds, etc.

Sorry, can't resist -- stocks are now at a permanent high.

It seems to be all about time scales. the brownian movement does seem be not important 50 years out, but nobody invest 50 years out.

I have to wonder what one share of the East India company, bought in 1600, would get you today? A small soverign country?

Probably not much. The Crown took the company over a century and a half ago. Though I guess the actual certificate might have some collectors value.

The Hudson Bay Company is still a going concern, though they're total valuation is something like 3 billion, so you probably would've lost money if you'd bought stock back when they essentially owned Canada.

I invest with a 50 year perspective. Or, to be more specific, to increase my expected living standard 30-50 years from now. Most young people should do the same.

Or maybe you should stop telling other people what they should like, and focus on being less of a dongwrangler.

"nobody invest 50 years"

Pension funds, endowment funds, wealthy grandparents all have reason to invest part of their money with a fifty year time horizon.

Canada has issued fifty year bonds so there is some demand for that time horizon:

The point that DeLong, or Shiller or no one else seems to look at is that EPS growth is slowing sharply.
From WW II to the late 1990 S&P EPS growth was 7%.

But it has been under that 7% trend since -- even now EPS is well below the old 7% trend.

The reason profits are at a record share of GDP is weak GDP growth as much or more as strong profits growth.

Given the big cyclical swings in EPS in the last three recession when EPS fell much more than in earlier cycles, I'm not sure what the new trend is, but it is clearly below the old post WW II trend.

I long though of the PE as an expression of the present value of a stream of 7% EPS growth.

But if trend EPS is now lower -- consistent with a stagnation scenario -- maybe the market is more overvalued than Schiller thinks.

Over-valued compared to what? That's the amazing part to me about all of this. 10 year TIPS at 0.25%. 30 year at 0.93%. How can stocks be overvalued? If CAFE hovers around 100, that's a break-even against bonds at these rates.

"To what" is precisely the right question. I suppose the answer is, "to housing", which was the primary target of FED policy. However, housing is as much a liquidity decision as it is an asset appreciation decision. The Fed threw salt in the water, hoping to lower the boiling point (rent/own decision), but all it really did was season the pasta (equity market).

Indeed, the real estate market crashed in 2008... and it's been a really excellent investment since then.

So yes, the alternative to stocks is real estate. Plainly.

+1. That so many people misunderstand this is a testament to the a lack of understanding of how the stock market, and the much more mathematically tractable bond market, work. That, and/or persistent risk aversion in the wake of the financial crisis.

Overvalued compared to real estate (rents!).

REITs have been doing gangbuster returns lately.

given the interest rates, I consider stocks fairly valued now.

But Brad de Long is a clear counter indicator. Makes me worry. Should I sell despite sound fundamentals?

especially with mpowell's comment in mind,

I should add, that my "fundamentals" are not Shiller with his CAPE

You should read the article to know why it is obvious that you did not read the article.

I did read it,

and therefore I added my second comment to be better understandable to the other readers.

In general some folks like deLong, Krugman, Roubini, Soros just have a long history of making the wrong calls. They are counter indicators.

For the last one, there was an interesting post mortem on FT alphaville, saying one thing in public and trading the opposite for his own book.

De Long was optimistic about stocks when that was the right call:

DeLong's not accounting for the fraud (Enron) factor. And his call is bad.

Also, the alternative isn't really bonds. It's real estate. There's a fraud factor there too of course, but it can be avoided, with care.

Using ten years moving averages of earnings to calculate P/E is an outright silly idea. It's Shiller's worst intellectual mistake, which is why it's so hugely popular among the investment dilettanti.

Anyway, P/E fails most miserably when you need it most. Remember March 2009. P/E is a poor man's buy/sell indicator, literally.

Actually the CAPE was indicating good value in March 2009. CAPE was 13.3 in March 2009, down from 25-27 or so for much of 2007.

The way CAPE is constructed, with the price component changing rapidly while the earnings component changes slowly, pretty much guarantees that it will "accurately" predict tops and bottoms, making it look like magic to the average financial journalist. DeLong's contribution (although he is not the first one to do this) is to thoughtfully think about and look at return distributions.

While I have great respect for Shiller, I don't understand his confidence that the CAPE is likely to return to it's historical average of around 16. There are several reasons why we might expect the average CAPE going forward to be higher than in the past:

1. The average levels of CAPE in most of the last century appear, with hindsight, to have been puzzlingly low. This is the well-known "equity premium puzzle."

2. There has been a large shift in corporate payout mix, from virtually all dividends in the past, to a roughly equal mix of dividends and share repurchases today. This by itself will add a couple of points to CAPE even if nothing else changes, (as shown in this post by the anonymous blogger who tweets as "Jesse Livermore"):

3. Some other accounting changes to the definition of profits might raise the CAPE as well, again see the linked blog post above.

4. Lower information and transaction costs and the rise of index investing have dramatically lowered the cost of maintaining a globally diversified portfolio. This decreases the raw rate of return for any given required rate of realized returns. For example if the costs of investing in equities fall by just 50 basis points, this would allow the required raw earnings yield to fall from 5% to 4.5%, corresponding to a rise in CAPE from 20 to 22, without changing realized returns for investors.

5. The real "risk free" return on treasuries seems to be very low by historic standards. Real returns on other forms of debt also appear low. This lowers the return stocks need to be attractive by comparison.

6. Large corporate cash balances, a "global savings glut," lower rates of real economic growth, possible "secular stagnation," all seem to point to the idea that real returns are somewhat harder to get than the past.

Some of these reasons are more certain than others, but taken together they seem to show that we have good reason to expect CAPE levels significantly above the historical average going forward.

Are there any countervailing reasons offsetting the list above, factors that would tend to make CAPE lower than in the past? I can't really think of any. And I haven't seen anybody else offering any.

+1 thanks for this post.

Stock repurchases generally have little to no value to investors over the long run; they're much worse than dividends. There have been studies on this. They benefit *management*, who gets to loot more out usually.

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Surely stock market returns will fluctuate.

Here are much better graphics showing historical rolling returns. They show that 10 holding period was not long enough to remove the risk even when the average real return was better than 6%.

Are you kidding me? Your graphs are crap compared to Delong's. He plots the same thing (rolling 10 year returns), but plots it against CAFE at the start of the time period. Also, his data goes back to 1881. And he discusses the data points that resulted in negative returns. They cluster in 3 time periods and in the first two you would have been crushed in bonds just as bad as equities. The only time period where bonds would have saved you was at the peak of the tech bubble. I can't believe you actually read the article.

Brad's data for the 19th century is (a) bad, like most such datasets, doesn't account for bankruptcies properly;
and (b) doesn't go back far enough.

That said, bonds have kind of sucked for quite a few decades.

Take for instance a company that for the
current period has more outstanding payables than they do receivables.

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I shifted a bunch of my savings into the S&P 500 directly in response to this post (really):

Thanks Brad DeLong! Not sure I believe him now though.

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