Despite political uncertainty, investors can still count on stocks
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A fundamental tenet of Wall Street is that the stock market dislikes uncertainty. The myopic focus of the media, both domestic and foreign, has been focused squarely on Donald TrumpDonald John TrumpBiden slams Trump over golf gif hitting Clinton Trump Jr. declines further Secret Service protection: report Report: Mueller warned Manafort to expect an indictment MORE and what he may or may not have done. Worse yet, are conjectures about what he could possibly do. In other words, with respect to U.S. politics, uncertainty abounds.

A common narrative is that Trump’s unpredictability and low approval ratings must be a negative for the stock market. Yet, inexplicably to some observers, the stock market keeps rising. To put this in perspective, on the same day a Washington Post headline read “Comey lays out case that Trump obstructed justice,” the NASDAQ market reached a new high.

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What gives? Those inside the Beltway, and many on Wall Street, have a difficult time rationalizing a rising stock market with governmental turmoil. Stock market naysayers point to the fact that the S&P 500 currently trades at a fairly rich price-to-earnings (P/E) ratio of 25.7. To put that in historical context, the index historically has sold at an average P/E ratio of 15.7.

 

Why would anyone invest in stocks if they are so expensively priced and there is so much political uncertainty? There is a perfectly rational explanation. An alternative to investing in stocks is to buy bonds. That is, stocks and bonds compete for investors’ dollars and need to be evaluated in relationship to each other. When bond yields are high, it is difficult to make the case for buying stocks unless they are very attractively priced. Conversely, when bond yields are low, it is much easier to make the case for buying stocks.

Currently, the 10-year Treasury bond yield is a paltry 2.2 percent. If held to maturity, the investor is locking in that rate of return for the next 10 years and might well be hard pressed to keep up with inflation over that period. Worse yet, if interest rates rise and the investor sells the bond before it matures, the rate of return will be lower than 2.2 percent. One can compare P/E ratios on stocks to yields on bonds in a very simplistic manner. A P/E ratio of 25.7 equates to an earnings yield (E/P) on stocks of 3.9 percent. Suddenly, stocks don’t look so overpriced.

Additionally, many investors focus on the short-term volatility of the stock market and neglect the long-term. Looking at longer term holding periods presents a different picture. Data compiled by Ibbotson Associates shows that over a 10-year time horizon, since 1926, the S&P 500 has failed to provide a return of at least 2.2 percent compounded annually only eight out of 82 times. To put that in perspective, long-term U.S. government bonds have failed to provide a return of at least 2.2 percent in 18 out of 82 10-year holding periods.

In an interview last month with CNBC’s Becky Quick, Berkshire Hathaway Chairman Warren Buffett said, “Measured against interest rates, stocks actually are on the cheap side compared to historic valuations. But the risk always is that interest rates go up a lot, and that brings stocks down. But I would say this, if the 10-year stays at 2.3 percent, and they would stay there for 10 years, you would regret very much not having bought stocks now.”

The message is that despite political uncertainty, a strong case exists for stocks for long-term investors. Then again, for long-term investors, a strong case generally always exists for stocks.

Robert R. Johnson, PhD, CFA, is president and chief executive officer of the American College of Financial Services. He is co-author of Strategic Value Investing, Invest with the Fed, and Investment Banking for Dummies.


The views expressed by contributors are their own and are not the views of The Hill.