Are stocks set for a terrible 10-year run?

By some estimates, stocks need to fall as much as 25 percent for them to offer compelling long-term returns.
M. Spencer Green

When it comes to long-term investing, valuation is (just about) everything. Price-to-earnings ratios (P/E) have a way of reverting to the mean over long periods of time, which is one explanation for why the S&P 500 is still almost 40 percent below its record inflation-adjusted peak, hit more than a decade ago. Stocks are still hung over from the tech bubble of the 90s.

So as fourth-quarter earnings season gets underway this week, investors may be surprised to learn that stocks are not nearly the bargain they appear, regardless of where the seemingly cheap forward and trailing P/E ratios of the S&P 500 stand now.

Earnings are cyclical, and they reached record levels in recent quarters thanks to cost cuts -- not revenue growth. Employers slashed jobs and input costs plunged during and after the recession, allowing corporate profit margins to expand faster than sales. That's where the torrid bottom-line growth came from.

But now margins appear to have peaked, and equity investors with long horizons would be wise to look at alternative ways of measuring market valuation.

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S&P 500 earnings are expected to increase just 7.8 percent year-over-year in the fourth quarter, according to data from Thomson Reuters, the slowest growth rate in two years. Sluggish sales have been a fact of life throughout the recovery. Now that energy and input costs have recovered from recession lows, and every ounce of productivity has been squeezed from workers, the corporate-profit trajectory is naturally going to slow.

That's why short-term measures of market valuation -- which typically look at just 12 months of actual or estimated earnings -- can be so deceiving. Right now, the forward P/E on the S&P 500 stands at just a bit more than 12, according to Birinyi Associates, suggesting that stocks are a screaming buy. The trailing P/E is compelling, too, at a historically below-average 15.

But once you use something called normalized earnings, which smoothes out the effect of the business cycle and abnormally high profit margins, stocks look poised to deliver lousy returns over the long term.

John Hussman, the well-regarded manager of Hussman Funds, reckons that when you look at normalized earnings, the S&P 500 is currently priced to deliver 10-year returns of just 4.9 percent annually. And, historically, valuing the market using cyclically adjusted earnings has predicted long-term returns remarkably well. See the chart, courtesy of Hussman Funds, below:

Hussman Funds

It's by this same method of valuing the market that legendary investor Jeremy Grantham of GMO comes to the conclusion that the fair value of the S&P 500 is closer to 950 to 1000 -- or as much as 25 percent below its current level. Indeed, the Boston-based money manager sees U.S. large-cap stocks returning just 2.1 percent over the next seven years.

In another depressing forecast, Yale economist Robert Shiller estimates stocks are too expensive by about 20 percent compared with their own long-term, cyclically adjusted average.

It's all very sobering news for equity investors, and serves to underscore the importance of asset allocation and regular rebalancing to achieve long-term financial goals. That will help you capture the best of the market's good times over the next decade -- and protect some of those gains when stocks are lagging, too.

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    Dan Burrows, a veteran of Aol's DailyFinance, SmartMoney and MarketWatch from Dow Jones, covers the markets and economy with an eye toward investing for the long haul.