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The Alternative Answer Daily

Stocks Won’t Be Enough

This post appeared originally on Forbes.com.

Heard this one from your broker? “Sure, there are problems out there, but the real question is whether you think the market will be higher or lower three years from now.” Most of us are optimists, so we buy.

OK, but the critical issue is really: how much higher? Charles Stucke, CIO of Guggenheim Investment Advisors, is out with some fascinating new research on that question. Spoiler alert: it signals disappointment for investors counting on strong equity returns over the next several years.

Before we start: I’m no fan of rigorously applying old formulas to new facts. The modern world is too complex –and rapidly evolving– for the patterns of the past to repeat themselves precisely. There simply is no precedent for the world’s largest economy being fueled by central bank liquidity experiments; as its second biggest tries to switch from centrally planned to a market driven; and its third largest falls into a demographic elevator shaft. Nor have we previously seen America as a great energy exporter, a development that will profoundly alter not only our economy, but many others. The wildcards are wilder than ever.

Nonetheless, Stucke’s take on two classic measurements of expected future yield for the stock market is illuminating. He drills down on what the Shiller PE and the equity risk premium are saying right now.

What’s the Shiller PE? Well, as you know, the standard S&P P/E ratio divides the cumulative price of a the index by the collective earnings of the constituent companies. But Professor Shiller rightly argues that short-term business cycles can distort this measurement. For example, traditional P/E ratios make the market look too expensive after severe recessions because the previous year’s earnings are abnormally low: just check out early 2009, when a PE of 94 told you to stay away from stocks just before a fantastic bull market run. (The opposite occurs at the end of expansions, when big previous earnings can make the market seem cheap).

The Shiller P/E addresses this issue by using a different “E”. Instead of dividing the market’s price by a single year’s earnings, it uses the average of the last ten (after inflation). That smoothes out the cycles and gives a truer picture of how expensive the market really is.

Stucke’s research examines the entire history of the Shiller, and divides it into pre- and post- WWII periods. Since 1945, he finds, the Schiller has had a strong track record projecting stocks’ 10 year forward returns. And here’s the news: it says we’re looking at 4% annual growth for US equities over the next several years.

Now, how about this “equity risk premium” thing? Historically, investors have demanded a greater return for investing in stocks than they have in bonds, because of the perceived extra risk equities represent. Today, that premium appears higher than usual: the ERP is somewhere around six, compared to a historical average around four.

Bulls like this: they assert that stock prices could therefore rise significantly from here, since that would bring the premium over bond rates down towards the long-term norm.

But Stucke’s analysis paints a different picture. He shows that during those few periods when interest rates have actually been this low, investors have gotten an equity risk premium of right about what they’re getting today (as measured by the Schiller PE). So by this yardstick, too, the market looks fully valued, and quite unlikely to deliver more than very modest returns from here.

The real point of Stucke’s work is not to predict poor equity returns. It’s to challenge investors with this question: if these gauges are indeed correct– and there certainly is at least a darn good chance they are– how can investors generate the extra returns they’ll need over the coming years? He suggests shifting towards much more active management, including alternative strategies such as activist investing and event driven funds.

My list would also include: MLPs; peer-to-peer lending; energy extraction partnerships; income-producing real assets, like farmland and infrastructure; seed stage technology investments; growth equity for pre-public companies; and the distressed real estate that banks are being forced to divest due to new capital requirements.

On a related note: the last couple of trading days emphasize, again, that bonds will not continue to serve their traditional volatility-dampening role in your portfolio (see Liquidiity Detox: Prepare for the Shakes over there on the left). Aside from adding new strategies for growth, then, you’ll need to add some that zig when the market zags. Look to long/short mutual and hedge funds; good global macro managers; and maybe add a dash of managed futures.