Why Stocks May Have More to Drop

Trading At The NYSE As U.S. Stocks Rise Amid Payroll Gains
A Wall Street sign stands outside the New York Stock Exchange (NYSE) in New York, U.S., on Friday, Jan. 8, 2016. The Standard & Poor's 500 Index fluctuated near a three-month low as energy shares followed a retreat in crude, overshadowing early optimism on China's moves to restore calm to its sinking markets and data that showed U.S. payrolls surged more than expected in December. Photographer: Michael Nagle/Bloomberg via Getty Images
Photograph by Bloomberg via Getty Images

Most Wall Street market strategists were calling stocks a buy before the market’s recent slide. So you would think that after a four-day drop of more than 900 points in the Dow Jones Industrial Average—the worst annual start for the market since at least 1896—equities would now present a downright bargain.

That may not necessarily be the case.

It’s generally true that the lower your entry point, the higher your future return. That’s because the market is a poor forecaster of earnings growth. Just because investors have pushed stocks up to lofty valuations doesn’t mean profits will wax extra-fast to justify the rich price-to-earnings multiples. Nor do low P/Es regularly foreshadow mediocre growth in profits.

The math is basic. Future profits are likely to grow at about the same rate whether investors have bid up P/Es or not. Therefore, you’ll make a lot more money over time buying when P/Es, and investor expectations, are modest. If prices are lower today than a few months ago, you’ll probably reap a higher return buying now than at the peak.

Obviously, investors are facing that scenario today. So how much more can they expect to pocket versus folks who bought equities at the peak? In other words, what’s the extra return you can expect by purchasing shares following the recent selloff? And is the decline sharp enough to create a genuine buying opportunity?

A good metric for predicting future returns is the average of the current dividend yield—the cash companies pay investors each quarter divided by the share price—and the earnings yield, which is the estimate of the profits a company is likely to generate for each dollar you’re paying for the stock. It’s a measure preferred by Chris Brightman, chief investment officer of Research Affiliates, a firm that oversees strategies for $154 billion in index funds. For the earnings yield, the best measure uses the adjusted P/E developed by Yale economist Robert Shiller, which removes distortions caused by spikes and valleys in profits. Simply flip to Shiller P/E to arrive at E/P—that’s the earnings yield.

At the market’s summit on May 22 of last year, the earnings yield stood at 3.73% (the inverse of the Shiller P/E of 26.8), and the dividend yield was 1.9%. The average of the two is 2.8%. Include 2% for inflation and the total expected return at the market peak was 4.8%.

Thanks to the S&P’s subsequent 9% decline, the dividend yield has risen to 2.2%, and the earnings yield has expanded to 4.1%. Hence, the average of the two, the expected return, has grown to just over 3.1%. Add inflation, and the best bet is that you’ll make about 5.1% a year going forward in a combination of dividends and capital gain.

Hence, despite all the shock and surprise over the market’s retreat, investors can expect a meager 0.3 percentage point bump in their future gains by purchasing stock at today’s reduced prices. How does that translate into returns?

If you’d placed $100,000 in an S&P index fund last May, you could expect your holdings to grow to $126,400 in five years. If you bought now, that figure would increase to $128,200, a difference of just $1,800. That 0.3 percentage point difference is so small that it compounds into only a meager edge over time.

One conclusion is that the selloff hasn’t improved prospects much for investors. The second conclusion is more fundamental: At these prices, stocks are still far from a bargain. “Prices have come down a lot, and that’s great, but they’re still way above the long-term average of the Shiller PE, or even the average of more recent decades,” notes Jim Masturzo, VP of the asset allocation group at Research Affiliates.

To reach the Shiller average P/E of around 19 that’s prevailed since 1990, the S&P would need to fall another 20% to 1560, into deep bear territory. Despite all the recent market noise, stocks aren’t anywhere near a screaming buy.

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