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I spent an enjoyable afternoon recently at the University of Toronto's Rotman School of Management listening to Burton Malkiel. Nearly three decades ago, Malkiel wrote a bestseller that's still in pri...

June 1, 2001  By Hank Bulmash, C.A., MBA

I spent an enjoyable afternoon recently at the University of Toronto’s Rotman School of Management listening to Burton Malkiel. Nearly three decades ago, Malkiel wrote a bestseller that’s still in print today. A Random Walk Down Wall Street argues that it is impossible to outperform the market over the long run without incurring greater than market level risk. To Malkiel’s way of thinking, you’re likely to be severely disappointed if you think 15% returns are in your future. In fact, 6% returns are far more likely.

This view should be afforded serious consideration. Malkiel is not a stock market analyst hoping for 15 minutes of fame on CNN. He is a distinguished professor of economics, and the author or editor of eight books in addition to A Random Walk. He has been dean of the Yale School of Organization, a member of the President’s Council of Economic advisors and chairman of the Economics Department at Princeton. Furthermore his experience is not limited to academia; he sits on the board of several major financial corporations.

It was Malkiel who popularized the idea that any mutual fund manager has about as much chance of beating the stock market as a monkey throwing darts. This perception provided the rationale for “automatic” investing through low fee index funds. When A Random Walk was first published, index funds barely existed. Today they form an enormous industry and represent the core holdings of millions of portfolios.

Malkiel noted that there will always be superinvestors like Warren Buffett. However, since it’s impossible in advance to know who they are, only hubris would lead you to expect that your investments will be guided by such a person. Nonetheless, most investors do make that assumption. After all, investing is inherently optimistic. No-one buys a stock anticipating a price decline.

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Based on the history of the last 20 years, it’s easy to believe that stock prices are due for a major upswing. From 1982 to 2000, the S&P 500 index of common stocks increased in value by an astounding 18.3% per year. What fueled that growth in prices? It wasn’t earnings growth. Earnings growth of the S&P 500 since 1946 has been fairly constant at 7% per year. For the 18 years from 1982 to 2000 earnings growth was 6.8% — just a little below average.

Malkiel pointed out that stock prices move up and down as a result of two things: (1) changes in corporate earnings, and (2) changes in Price/Earnings multiples. The huge increases in prices were a result of an expansion of P/E multiples. At the beginning of the period in 1982, the P/E multiple for the S&P 500 was about 8. That means that investors were willing to spend $8 on a stock (price) to buy $1 of earnings. In contrast at its peak in 2000, the market had a P/E multiple of 29.

In other words, if you bought stock in a company that had earnings of $100 in 1982, you might have paid $800 for the whole business. Eighteen years later if the business still earned $100, and you sold it for the market multiple in 2000, you would have received $2,900. That’s a remarkable rate of return for a company that failed to increase its profits for nearly two decades.

Why did this happen? In the 1970s, oil and commodity shocks led to heartbreaking increases in consumer price levels. For a while the future of the industrial world looked so bleak that perfectly good companies were sold for far less than the replacement value of their assets. Few people wanted to buy stocks when bonds were yielding 18%, bank loans earned 20% and real economic growth was anaemic.

As a result of this lack of interest, stocks sold at unusually cheap prices. Historically the market P/E multiple for stocks has generally been about 15 — reflecting the S&P 500 growth rate of 6% to 7%. In the mid 1980s when inflation growth began to slow, people were happy to buy stocks at rock bottom prices — at P/E multiples that were half of historical averages. Over time as people realized that inflation was less of a threat, a flight to equities ensued and prices were bid up and up and up. It wasn’t earnings growth that pushed stock prices higher. It was disinflation, and disinflation was incorporated into stock market prices though the expansion of P/E multiples.

But what about now? Despite the decline in the markets, the S&P 500 average P/E multiple is about 20 — still high by historical standards. P/Es can expand only when the market as a whole is undervalued because P/E expansion is really a correction to normality by an undervalued market. Malkiel feels that current prices are too high to yield much in the way of P/E expansion, and in fact more compression might be in store. Not surprisingly stock prices do best when they benefit from both P/E expansion and earnings growth.

If Malkiel is right and stock prices don’t benefit from P/E expansion for the next 10 years, they will be solely dependent on earnings growth for increases in value — and stock price changes will correlate with earnings growth of 6% per year. Historical analysis seems to confirm Malkiel’s thesis. In the past, investors have earned rates of return of less than 8% for the 10 years following the purchase of stocks in high P/E markets.

As an alternative, Malkiel suggests that investors look to other asset categories: commercial real estate (which can be purchased through REITs), high yield non-junk bonds (currently generating interest of about 12%) and inflation-indexed treasury bonds.

Perhaps Malkiel’s is a voice worth listening to.

Hank T. Bulmash, MBA, CA, is a principal with Bullmash Cullemore, chartered accountants of Toronto.

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