Why I Like This Market

So…I’m not a lawyer, but I gather I’m supposed to put a disclaimer on stuff like this. This is not offered as investment advice, just an explanation of why I make the decisions that I happen to be making for my own personal portfolio. Others have to make their own decisions for their own reasons, or hire a real investment advisor with a…series whatever… As I said, I’m not a lawyer.

I was going to give three reasons that I like the US equity market right now, but I think I’m going to give four, starting from zero:

0. I always like stocks. The stock market has a long history of tending to go up, and the returns compared to other assets are hard to justify based on relative risks. Maybe if you’re really smart you can time the market and figure out when to be out, but there’s a big burden of proof there.

1. You might think the stock market is expensive now if you compare P/E ratios to historical tendencies, but compared to other asset classes, stocks are pretty cheap. I like to compare the S&P 500 dividend yield to the yield on 20 year TIPS. Based on my read of the historical data, “fair value” is that they should be about the same: the growth from reinvested profits roughly compensates for the safety advantage of Treasuries. Right now the spread is about 166 basis points, about as wide as it’s been in the last few years. I’ve also played around with things like correcting for changes in typical payout ratios or using cyclically adjusted earnings yield instead of dividend yield, but it all leads to the same conclusion: compared to bonds, stocks are cheap.

Now you might say, “But all assets are expensive now!” The problem is, by definition, you can’t own something that’s not an asset. The competition for “all assets” is consumption. Is the world about to start liquidating assets and go into a consumption boom so big that it will push up required stock yields faster than it pushes up earnings? Umm…maybe…but that’s not the impression I get.

You might also be concerned that labor costs are rising, so maybe earnings won’t rise as fast as they have in the past. That might be a concern if I were using lagging earnings as my measure of value. But I presume that dividend payout decisions take into account expected changes in labor costs. And cyclically adjusted earnings — using the average of the last 10 years' data — include the Great Recession, which surely sets the bar low enough that some increasing labor costs are not going to be a problem.

2. As I argued on Twitter last week, Brexit is not a clear negative for US equities. You can make a case that it’s bad for European equities on both sides of the channel, since it’s actually going to screw things up over there, not to mention creating uncertainty about exactly how it’s going to screw things up. But for the US, the only major net adverse economic effect, if any, would be on the demand side. That means it’s the Fed’s job to take care of, and if the Fed is willing and able to do its job, the effect should be neutralized.

But it gets better. If there is an adverse demand-side effect on the US, part of it will still be there even if stocks go back up to the level where they would otherwise have been. To fully offset such a demand-side effect from Brexit, the Fed needs stock prices to go up higher than they would have without Brexit. So, again assuming the Fed is willing and able to do its job, Brexit is a net plus for US equities.

Is the Fed willing and able to do its job? Maybe not, but I’m pretty optimistic. Janet Yellen is a smart cookie. Any lingering doubts I have are offset by the expected favorable effect on equities if the Fed does do what it should.

3. What the hell happened on the day of the referendum? I mean, there was one poll showing Remain winning by a fairly narrow margin, and suddenly markets were like, “Thank you, Lord! The Era of Eternal Blessings has arrived!” If you ask me, that was a market packed with people who were ready to buy and just looking for an excuse. Then the voters from Sunderland took away the eternal blessings. But here we are a week later, and markets are seemingly euphoric again, for no apparent reason. (Well, maybe the reason is that bond yields have come down, but that was supposed to be part of the bad scenario, too, wasn’t it?) I submit that there are a lot of investors out there who really, really, really want to buy stocks, and I don’t plan to make it easy for them.

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