Friday, November 2, 2012

U.S. Equities: An Expensive, Clean Dirty Shirt?

I'm paraphrasing Bill Gross' comment about U.S. Treasuries and expanding it to the U.S. equity markets.

Cliff Asness of AQR Capital Management put out a third quarter bulletin to investors in which he talked about the Cyclically Adjusted Price-Earnings ratio ("CAPE") of Robert Shiller.  Depending on how you look at the long-term picture of CAPE, the equity markets are relatively cheap, or not.

The bullish case would say that the CAPE at 9/30/2012 was 22.5 times the average of ten year trailing real earnings.  This is one-half the level of 1999-2000, at the peak of the market bubble.  So, we should feel 'the pump' as the weightlifters would say.

When I first looked at his chart, it's clear to see the bullish conclusion, but then the other side is also evident. Asness notes that the CAPE time series has spent 80% of its time below the current level of 22.5.  So, he concludes, based on some additional partitioning of the long period, that someone expecting a 10% nominal equity return (about 8% real) is betting on exceptional returns compared to history.

This gets us back to Bill Gross' metaphor. Emerging markets, for all the bullish broker comments, aren't attracting the big money, such as Norges Bank Investment Management. There has been a flight to liquidity, size and decent dividend yields, which largely spells U.S. equity markets.

However, we've seen in repeated corporate reports a blizzard of financially engineered quarters, with simultaneous challenges expressed about future revenue prospects.  Next year, comparing to these strong quarters might be problematical.  Shouldn't the market move downward?

The typical buy and hold investor, who isn't foolish enough to think that he can trade against the market with their broker's option software, should find his prospective returns being truly circumscribed.  Thanks, Uncle Ben, for nothing!

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