Study: Stock Prospects “Rosy” for Long Term

Examining historical trends in the 10-year price/earnings ratio, bond yield spreads, and equity risk level premiums, Professors Dale L. Domian and WIlliam Reichenstein make the case that now is a good time to buy stocks ($$) in a research piece published by the American Association of Individual Investors.

Domian, of York University in Toronto, and Reichenstein, of Baylor University, say their research shows that — while there are no guarantees — “the good news is that long-term stock prospects appear relatively generous from here. … We encourage investors not to bail out of the stock market.”

The professors say that history shows several measures appear to have some predictive ability of future stock returns, including:

The 10-year (Shiller) P/E: Developed by Robert Shiller, this measure uses the market’s current price and its 10-year average earnings, to limit the impact of cyclical earnings figures. Generally, Domian and Reichenstein write, times when the 10-year P/E has been low are followed by periods of high stock returns; periods where the figure is high have been followed by low returns. In November, when the market was not much lower than it is now, the 10-year P/E was 13.4 — the lowest it had been in 21 years, a bullish signal.

The Baa-Aaa Spread: Domian and Reichenstein say this spread — which represents the difference in yields between the lowest- and highest-level groups of investment-grade bonds — tends to be high before periods of stock market outperformance. A wide spread indicates a high risk premium for stocks, which usually means bigger future rewards. In November, the spread was 3.07 percent, the professors write — the highest level since 1933.

The Value Line Predictor: This uses Value Line’s weekly projections for future dividend yields and stock returns. By adding those two together and subtracting the Treasury bill yield, you get an estimate of the risk premium for stocks. This variable indicates that stocks should beat Treasury bills by almost 30 percent over the next 18 months, Domian and Reichenstein conclude.

The professors are careful to note that, while they generally have been good predictors of future market movements, the three indicators listed above have gotten things wrong before; they aren’t perfect. But, they conclude that their current unanimity about stocks being good investments right now is a good sign.

Domian and Reichenstein also talk about emotion, and how it often causes investors to buy high and sell low. Their advice to avoid such behavior in the current market involves portfolio rebalancing. By rebalancing your portfolio back to a target asset allocation (for example, 60% stocks and 40% bonds), you ensure that you are buying stocks after they’ve gone down in value and selling them after they’ve gone up in value. At a time like this, it may also be wise to slightly increase the portion of your portfolio in stocks because of their attractive valuations. They say investors should also try to save more in the current climate, and offer some special recommendations for retirees.