My Response to Jeff Kleintop

In the latest installment of my Five Good Questions series (AdvisorOne version here), LPL strategist Jeff Kleintop offers a bullish near-term perspective on the equities market.  “We continue to subscribe to the forecast we have held all year for modest single-digit gains for the stock market.  We believe the gap between feelings and facts got too wide with pessimistic investors failing to notice solid economic and profit reports and progress dealing with the challenges in Europe.”  There’s nothing wrong with such a view on its face, even though I am decidedly less sanguine – reasonable minds can differ and forecasting is always fraught with peril and error.  Moreover, near-term forecasting is especially difficult.

But something he says later troubles me a lot.

I pointed out what I call “leading investment indicators” (PE10, dividend yields, Q, market cap-to-GDP, interest rates) that are very negative and asked how these measures impact his views.  Jeff replied as follows:  “We believe that history has made it clear that the most consistently accurate predictor of long-term stock market returns is the S&P 500 price-to-earnings ratio (P/E).”  That reply makes sense coming from a bull because PE is fairly low today – suggesting healthy returns going forward (in Jeff’s words, “[t]he level of the P/E and the annualized return on stocks over the next 10 years have a very close relationship”).

That answer alone gives me pause because even though Jeff claims that P/E “has a nearly perfect track record of forecasting long-term performance,” solid academic research supports the view that P/E isn’t as good a predictor of future returns as PE10.  As my friend Wade Pfau pointed out to me, that’s largely because earnings can be so volatile.  Even so, PE10 can only explain about 30% of the movements in the subsequent 10-year real returns on the S&P 500.  Even the best predictors are subject to randomness (noise).  There is nothing like certainty in the markets.  Note these charts below (from Wade).

I’m not terribly troubled by Jeff’s use of P/E per se (“the trailing PE has a nearly perfect track record of forecasting stock market performance over the next 10 years”) in that P/E does explain about 27% of the subsequent real 10-year total returns – that’s nothing like the claimed “nearly perfect,” but it’s noteworthy nonetheless.  I’m much more troubled by Jeff’s outright rejection of PE10 (“the trailing PE has a nearly perfect track record of forecasting stock market performance over the next 10 years – the 10-year PE does not”)  because the data does not support it. 

As noted above, Jeff’s claim overstates the impact of P/E, but it’s also dead wrong on PE10, as shown above and as Wade demonstrates in a recent paper.  Perhaps more significantly, the way Jeff explains PE10 makes it sound like he isn’t using the proper definition.  PE10 is not a 10-year moving average of P/E values.  Rather, it is the current stock price divided by the trailing 10-year average of real earnings. As Jeff defines it, “PE10” would indeed be an unlikely predictor of future returns.  I’m also troubled that Jeff relies solely upon P/E and neglects other indicators (such as DY), perhaps because they do not support his desired result.

In another of Wade’s papers, he discusses PE10 and DY10 as reasonable predictors of future returns, but note how he defines them.  DY10 is the 10-year moving average of dividend yields, but PE10 is current price divided by the 10-year moving average of real earnings.  As Wade argues in his paper:

“The dividend yield (DY) is aggregate dividends divided by the stock price. I find that a 10-year moving average for the dividend yield (DY10) provides a better model fit. This can be justified as a way to obtain the underlying trend in dividend payments after removing the cyclical trend in stock prices. Unlike EY10 [this is just 100 divided by PE10], the 10-year moving average for DY is not the average of previous dividends over current price, but rather the average dividend yield. Because EY10 already includes the current price, another variable with current price is not needed.”

Using this definition, PE10 is a reasonable predictor of future returns (it’s the best we have) and, today, does not provide much solace for the bulls.1 This definitional difference may simply reflect a difference of opinion.  However (and perhaps I’m being too cynical for my own good here), as a noteworthy new blog points out

“You may have been under the assumption that analysts, economists and strategists are compensated to the extent they are correct in their forecasts. This is only true to the extent that accurate predictions generate trade commission. In the end, analysts, strategists and economists are paid directly in accordance to how much trading commission can be generated from their reports. Importantly, bearish news is not conducive to trade generation. Even in the rare instance where bearish news does instigate sell ticket commission, unlike buys a sell does not imply repeat business. Stocks that are bought need to be sold, with commission on both sides. The cash realized by sells may never return to the trade desk again.”

As every equities-jockey is well aware, it’s hard to make money being bearish.  Thus LPL has an interest in being bullish irrespective of the data.  Jeff’s forecast needs to be viewed in that light.


1 I hasten to emphasize that PE10 does not provide much solace for the bulls over the longer-term.  Finding a near-term trading strategy using valuations has proven vexingly difficult.  As Keynes put it, the market can remain irrational longer than you can remain solvent.

Five Good Questions for Jeff Kleintop

Jeffrey Kleintop serves as executive vice president and chief market strategist of LPL Financial, where he establishes market forecasts, helps define the tactical allocation used to help manage $77 billion in assets, and authors several flagship research publications, including weekly market reports and white papers on investment decision-making.

As a nationally recognized strategist, Mr. Kleintop is regularly sought after to speak to the national media—including Bloomberg, CNBC, and Fox Business—as well as at financial advisor and financial services industry events. He was featured in the Wall Street Journal article “Wall Street’s Best and Brightest” and was called “One of Wall Street’s best long-term thinkers” by The New York Times. Mr. Kleintop is the author of the popular investment book Market Evolution: How to Profit in Today’s Changing Financial Markets, which was published in 2006.

Prior to joining LPL Financial in 2007, Mr. Kleintop served as chief investment strategist at PNC Financial Services Group for seven years. At PNC, he helped define the asset allocation and portfolio strategy for over $50 billion in assets under management, served as vice chairman of the investment policy committee, and was co-portfolio manager for $10 billion advantage portfolios of large-cap growth, value, and core U.S. stocks. Prior to PNC, Mr. Kleintop served as senior investment analyst at Aris Corp of America, where he was instrumental in founding the registered investment advisor program that grew, within five years, from a small local firm with $300 million in assets into a regional asset manager with nearly $2 billion under management.

Mr. Kleintop has a Bachelor of Science in business administration and finance from the University of Delaware and an MBA in finance from Pennsylvania State University. He is a Chartered Financial Analyst and is Series 7, 65, 86, and 87 registered.

I am pleased that Jeff has agreed to answer what I hope are Five Good Questions. My questions are numbered and in italics.  Jeff’s answers follow.

1. Back in July, you anticipated a rally over the second half of 2011 and recently confirmed that view.  Why hasn’t that happened (at least so far) and what do you expect today?

We continue to subscribe to the forecast we have held all year for modest single-digit gains for the stock market.  We believe the gap between feelings and facts got too wide with pessimistic investors failing to notice solid economic and profit reports and progress dealing with the challenges in Europe.  October, often the month that declines end and rallies begin, has brought the rally back to positive territory on the year for the major indexes.  Having experienced a powerful double-digit rally from the lows, we anticipate modest additional gains accompanied by volatility for the remainder of the year as the markets end the year in line with our forecast.

2. The best measures we have of forward-looking long-term return projections for the equity markets, what I call “leading investment indicators” (PE10, dividend yields, Q, market cap-to-GDP, interest rates), are very negative.  How do these measures impact both your long-term and nearer-term forecasts and expectations?

We believe that history has made it clear that the most consistently accurate predictor of long-term stock market returns is the S&P 500 price-to-earnings ratio (P/E). The P/E is obtained by taking the price level of the index and dividing it by the earnings per share over the past four quarters. Essentially, the P/E is how many dollars investors are currently willing to pay per dollar of current earnings. The level of the P/E and the annualized return on stocks over the next 10 years have a very close relationship.  In essence, the lower the P/E, the higher the return over the next 10 years.  Currently, this relationship predicts that high single-digit gains are likely, on average per year, for the stock market over the next 10 years. 

Despite the fact that the P/E has a nearly perfect track record of forecasting long-term performance, many have been selling and believe that it is different this time given the troubled banks, European credit problems, geopolitical tensions, concerns over both inflation and deflation, the U.S. budget deficit, threat of rising tax rates, and uneven economic data, among other concerns. We do not dismiss these issues.  However, the P/E has demonstrated consistent success predicting long-term returns over the entire history of the S&P 500 index—going all the way back to the 1930s! 

Investors have always faced challenges. Since 1928, the S&P 500 has weathered massive bank failures, a dozen European countries defaulting, world war, double-digit inflation, top marginal income and dividend tax rates of about 90 percent, the percentage of U.S. government debt-to-GDP at double the current level, not to mention the Great Depression. And yet, through all of these unprecedented events the P/E remained a consistently accurate forecaster of future long-term returns.

The annualized loss for stock market investors during decade of the 2000s was the result of the record high 30 P/E 10 years ago in early 2000. However, we believe the current P/E of about 12 forecasts a better decade for performance ahead. The current P/E of around 12 suggests a 7-8% price return for the S&P 500.  The addition of a 2% dividend yield may result in a total return of 9-10%. 

Based on this relationship between future returns and P/E, the stock market’s lowest valuations in 20 years suggests this is the best time in 20 years for long-term investors to be buying, not selling, stocks.

By way of contrast, the point of PE 10 (the CAPE) is to make an explicit adjustment in the calculation for the business cycle.  Perhaps, but smoothing valuations over 10 years is not the best way to do that. Looking at the average of the last 10 years of prices makes little sense to me.  You pay today’s price when you buy – not the 10-year average.   Go to the gas station and try to pay the 10 year average for your gasoline and see what happens.  It doesn’t make sense. In addition, the S&P 500 index has had a tremendous amount of turnover in the past 10 years.  I don’t think what Lehman earned in 2004 matters to S&P 500 valuations today. 

But most importantly, as you can see in the chart below, the trailing PE has a nearly perfect track record of forecasting stock market performance over the next 10 years – the 10-year PE does not.  It worked in the Great Depression, it worked in WWII, it worked in the inflation spiral of the 1970s, it worked in the booming 1980s and 1990s and it worked in the past decade.

Source:  LPL Financial, Thomson Financial, Bloomberg data

3.  Are the Efficient Market Hypothesis and Modern Portfolio Theory on life support or even dead?  Why or why not?

I often refer to Charles Darwin’s statement from On the Origin of the Species when it comes to what is most important to investment survival in today’s markets: “It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.”

Investors face a challenging environment today. The drivers of investment performance are undergoing an evolutionary change that is resulting in volatile and below-average financial market performance. Such conditions place a premium on adaptation and innovation, and make proactive investment decision-making more valuable than ever. A new portfolio framework is necessary to exploit opportunities and achieve performance goals.

In the environment that confronts investors over the coming years, an adaptive approach to investing is likely to prove to be more valuable than the static models proposed by out-of-date theories.  Incorporating themes into investing is more important than ever.  And remember, that with the price you pay so important to long-term performance, taking advantage of market volatility to seek opportunities can be very valuable and may result in returns in excess of those offered by static indexes.

4. You have argued that the 2012 election is a big one for investors – why do you think so?

The 2012 election is likely to be consequential for investors.  There is a growing consensus that a plan to save about $4 to 5 trillion over the next decade is necessary to stabilize the debt-to-GDP ratio in the United States. Despite the efforts of the “super-committee” tasked with finding the $1.5 trillion agreed to in the terms of the debt ceiling deal crafted in early August, a package this size is unlikely to become law before the election. 

Since congress is unlikely to pass a major deficit reduction bill before the 2012 election, the outcome will have major implications for investors.  The party to emerge in control will forge the decisions that will represent one of the biggest shifts in the federal budget policy since WWII. 

Failure to pass a major deficit reduction package, regardless of what the rating agencies do, will likely result in investors loss of faith that the federal government get on a fiscally sustainable path absent a financial crisis.  Of course, this loss of faith would help to produce the crisis, with major implications for the markets, and force a major deficit reduction deal. 

Regardless of the details of the plan – and we have many proposals to choose from that blend a mix of tax increases and spending cuts – most proposals phase in the impact so that it isn’t until five years from now that the full impact would be felt.  The cuts would likely be equivalent to about 3% of GDP, or about 14% of the federal budget.  This would be one of the biggest policy shifts in modern U.S. history.  While the markets may welcome a resolution of the uncertainty and a path to fiscal sustainability, certain sectors may feel the brunt of the cuts, such as Health Care and the Defense industry.  Other asset classes may be impact as well if changes are made to the tax advantaged status of municipal bonds for some taxpayers. 

As we look out to the next few years, the old adage that the market likes “gridlock” or balanced government between the two parties may not hold.  It is apparent in recent market performance that investors recognize that substantial, defining fiscal policy changes – difficult to forge in a divided congress – are needed.  Based on polling data it appears that the GOP may retain control of the House and gain control of the Senate, by a small margin.  Having both houses of congress in the hands of one party increases the odds of significant policy actions.

5. What do you make of the Occupy Wall Street phenomenon, which claims that Wall Street has been cheating rather than winning?  Are some major changes desirable and, if so, which ones?

The core of the protest movement appears to be driven by a sense that only a few are succeeding while many are falling further behind as personal income lags inflation and the unemployment rate remains stubbornly high.  We anticipate private sector employment growth to be 150,000 to 200,000 per month over the next 12 months.  This is likely not enough to bring down the employment rate materially and may sustain the protest movement over the next year as we approach the next election. 


This piece is part of my Five Good Questions series at AdvisorOne and is available there.  Others in the series: