A recipe for stock market volatility

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By Mark Hulbert,MarketWatch | MarketWatch – 8 hours ago
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CHAPEL HILL, N.C. (MarketWatch) — Fasten your seat belts: The stock market is unlikely to calm down any time soon.

On the contrary, we’re likely to see more of the same kind of volatility that has characterized the markets in recent months — such as seen this week by Monday’s loss of $268 billion in the collective value of all U.S. stocks, followed by a $271 billion gain on Tuesday.

That at least is the sobering message I got from Lawrence G. Tint, chairman of Quantal International, a firm that conducts risk modeling for institutional investors.

In an interview, he argued that abnormally high stock market volatility will persist so long as no major asset class offers attractive long-term returns.

Because of this situation, many investors who are in the stock market are little more than fair-weather friends. They remain in equities not because they are excited about the stock market’s long-term returns, according to Tint, but instead because they have no good alternative.

“If an investor chooses to get out of stocks,” Tint asked, “where is he going to put his money?” The only other market that is large enough to be a major alternative to equities is the bond market, and its expected real rate of return right now is clearly negative.

As a result, he argues, the stock market’s level is not being supported by fundamentals as much as it is by investor psychology. And since investors are notoriously fickle, the market is “unusually susceptible to mood swings among investors.”

Tint’s argument prompted me to place the current situation in the stock and bond markets in an historical perspective. I relied on the database maintained by Yale University professor Robert Shiller, which contains monthly readings back to 1871 for the stock market, corporate earnings, inflation, and the long-term bond yield.

In none of the intervening 140 years has Shiller’s version of the price/earnings ratio been as high as it is now when the bond market offered such low expected returns. The absence of a good alternative to stocks that Tint refers to is historically unprecedented.

Only 25% of the time since 1871, in fact, was Shiller’s P/E ratio higher than it is today — the market’s weakness since April notwithstanding. Consider where long-term interest rates stood on past occasions when Shiller’s P/E ratio was particularly high:

Early 2000, the all-time peak level for the ratio, right before the Internet bubble burst. The 10-year Treasury yield stood then at 6.7%. Subtracting out the trailing 12-month rate of inflation, the real yield was 3.9%.

Early Fall, 1929, right before the 1929 stock market crash — the second-highest level over the last 140 years of Shiller’s P/E. The long bond then yielded 3.4% on a nominal basis, and since inflation was then so low, the real yield was close to 3%.

Today, in contrast, the 10-year Treasury has negative real expected rate of return. In fact, when we subtract the trailing 12-month change in the Consumer Price Index from the nominal 10-year yield, that real rate of return is minus 2.3%.

It’s not a pretty picture.

If there is any short-term solace in all this, it’s that these factors primarily influence the markets’ long-term returns. Shiller’s P/E, for example, has its greatest explanatory power at the 10-year horizon.

And with the markets as susceptible as they are to investor emotions, it’s possible that “animal spirits,” to use Keynes’ famous phrase, could prop up the stock market for a while longer.

Nevertheless, Tint concludes, “It’s hard to imagine that this decade won’t be a disappointing one, not just for stocks but for all asset classes.”
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
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