Is Barry too bullish?

The estimable Barry Ritholtz writes in the Washington Post that the current stock market rally is the most hated in history (strong words requiring impressive knowledge of the sentiment of previous rallies), and that investors, still battle-scarred from 2008-2009, are holding too much cash. In other words, investors should stop sitting on cash, which is a drag on portfolios, and own more stocks. Indeed the return on cash is virtually zero so that holding it necessarily guarantees a negative real or inflation-adjusted return. Fair enough….

Moreover, according to Ritholtz, investors don’t have the ability to sit on cash when things get expensive (like Warren Buffett, who’s been known to keep $20 billion to $40 billion on hand), so they should just own stocks for the long run.

Ritholtz’s desire to make his argument causes him to cite the cyclically-adjusted PE ratio (CAPE), which is currently at 25, but he cites it in relation to GDP. The CAPE ratio has nothing to do with GDP. It’s the current price of the S&P 500 Index versus the past 10-years’ worth of inflation-adjusted earnings. It’s proven to be a good way to appraise the market, and its historical average is around 16.5, making the market look expensive. Another metric (Warren Buffett’s favorite, it seems) is total stock market capitalization relative to GDP. So Ritholtz confuses the two metrics when he says “We are told [stocks] carry high cyclically adjusted price-earnings valuations relative to GDP.”

Ritholtz also takes issue with commentators who worry about profits being at all-time highs. But the work of Jeremy Grantham and his colleagues James Montier and Ben Inker indicates that profit margins have a very strong tendency to mean-revert (free sign-up required). And it’s intuitive that in a capitalist system extraordinary profit margins will be competed away. So, yes, it is indeed worrisome that margins are at all-time highs.

It’s true that we’ve probably been hearing more about the Shiller PE than usual since Robert Shiller recently won the Nobel Price in economics for his work (originally taken from Benjamin Graham and David Dodd). But the Shiller PE and Tobin’s Q (also at historically high levels) have shown good probabilities of predicting the next decade’s worth of stock market returns, though certainly not the next quarter’s or year’s worth of returns. With the Shiller PE now at 25 (the long term average is 16.5), expected returns are in the 4% range for the next decade.

Assuming the 4% return is accurate, maybe stocks are indeed the place to be. You won’t get that in a 10-Year US Treasury at the moment, for example. But is that the only way of looking at the investment landscape? Are you being paid adequately in absolute terms for the risk of owning stocks at a 25 CAPE? Might there be a moment over the next few years when you get an opportunity to make purchases at significantly cheaper prices? This isn’t an argument for exiting stocks altogether; it’s almost never a good idea for average investors to enter and exit asset classes entirely. But isn’t some elevated cash warranted at this elevated Shiller PE?

Additionally, Ritholtz doesn’t contemplate how much the boost in earnings we’ve seen off of the horrible trough of 2008 is the result of government and Federal Reserve stimulus. Is the economy healthy enough to generate profits when the stimulant is removed? Ritholtz doesn’t say, and it’s likely that nobody knows. But if nobody knows, what does operating with a margin of safety mean? Simply staying fully invested, or holding a bit of extra cash? The Federal Reserve has been conducting an experiment the likes of which we’ve never seen before; it has claimed it is “learning by doing.” Shouldn’t this be enough to spur some caution, and encourage investors to hold a bit more cash?

Also, most recently, we’ve been seeing the opposite of what Ritholtz argues. Stock mutual fund flows are positive lately, not negative. This may not be a hated rally at all. In fact, as it proceeds, investors are adding more and more money at higher and higher prices. Egged on by Ritholtz, they run the risk of suffering the fate they always seem to while intelligent value investors may be rewarded for their caution.

Even if Ritholtz is correct that this rally is hated (and it would be the first time people got less excited, not more, as prices rose in my experience), shouldn’t higher prices beget some skepticism? Do you really want to pay more for the merchandise you buy? Don’t the best investors tap-dance when prices get lower instead of higher? Nobody should run for the hills. But nobody should pile into stocks indiscriminately either at this point.

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