Brace yourself for meager U.S. stock returns

NORTHVALE, N.J. (MarketWatch) � Does your financial adviser subscribe to the idea of �stocks for the long run?� Are you warned against trying to time the market, and fed platitudes about sticking with your preset exposure to stocks through both lean and abundant years?

Well, listen up. It may not be easy to dance in and out of stocks, but there�s a good way of assessing the market�s valuation and setting expectations for likely returns over the next decade.

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It�s called the�Shiller P/E,� and it can help you make a reasonable assessment of whether the U.S. and international markets are priced cheaply, dearly, or at the average.

In devising the metric, Yale University professor Robert Shiller reprised the work of Warren Buffett�s mentor, Benjamin Graham, who argued that looking at a stock�s or the market�s most recent earnings could be misleading. Any single year can be unusually good or bad for a company or for the economy, so it�s more indicative to take the price of a stock or the market versus average earnings of a stock or the market over a full business cycle to understand if it�s cheap or expensive.

On his website, Shiller has tallied earnings data for the U.S. stock market over the past century, adjusted it for inflation, and performed the cyclical adjustment or 10-year averaging for which Graham argued. See Shiller�s website.

It turns out that the market has traded at around a 16 Shiller P/E, on average. In other words, on average, people have paid 16x for past 10-year average earnings to own the market. Yet the Shiller P/E has fluctuated, soaring to almost 35 in 1929 and an astronomic 45 in 2000.

Does that mean the Shiller P/E is a poor valuation metric? Just the opposite. The years 1929 and 2000 may ring a bell � they�re when the market reached notable peaks and began to crash. So the Shiller P/E told you when you were in dangerous territory and paying too much for earnings.

Lower your expectations

If you�re starting to think there�s something here, you�re right. Shiller P/E isn�t a silly predictor that follows skirt lengths or Super Bowl winners. As Buffett reminds us, a stock is an ownership unit of a business, which means when you buy it, you�re buying a claim on the business�s future earnings. The best way to assess whether you�re paying a decent price or not for those earnings, whether for a single business or the entire market, is to �cyclically adjust� or average the past earnings. That�s what the Shiller P/E does.

John Coumarianos

A recent research paper by hedge fund manager Cliff Asness shows that the Shiller P/E is pretty good at predicting future 10-year returns of the stock market. If you buy at a below-average Shiller P/E, you�ll tend to make above average returns for the next decade, and if you buy at an above-average Shiller P/E, you�ll tend to make below-average returns for the next decade.

In fact, the metric is so good that, on average, future returns rise as purchase price falls, and vice versa, in predictable and intuitive fashion throughout history. Read the research paper here.

So where is the U.S. market�s Shiller P/E now? It�s in the low 20s, above its long-term average of 16, meaning you should expect meager returns over the next decade. How meager? Well, you may keep up with inflation, but not much more, according to Asness�s historical data.

Now, it�s true that U.S. stocks could again reach a Shiller P/E of 35 or even 45, making the next decade a wonderful one for stock investors. Or it�s possible that earnings could increase dramatically, giving you a greater return for any dollars invested today, regardless of whether the Shiller P/E expands or not.

But Asness shows that the data warns you not to count on either of these things. Investing with the Shiller P/E at this current level has led to happy results for the next decade so infrequently, you�d clearly be imprudent to expect it.

Ultimately Asness argues for using the Shiller P/E, when it�s between 10 and 30, as a way to set expectations rather than as a way to trade in and out of stocks � though setting expectations is important enough and typically underappreciated by most investors and advisers. Clients don�t want to hear bad news, so advisers don�t want to give it to them. Such is the perverse interplay between most advisers and most clients.

Find global values

Not to be overly optimistic, but I think an investor can use the Shiller P/E, when it�s between 10 and 30, to make at least one portfolio adjustment.

Academic research shows that the Shiller P/E works overseas about as well as it does in the U.S., so an investor can use the metric to find cheaper markets than the Standard & Poor�s 500-stock indexSPX �.

In fact, many foreign markets now are more attractively valued than the U.S. market. They have their risks � Shiller P/Es don�t often get low without reason. But I might rather pay a Shiller P/E of 10-12 for some European countries or emerging markets than a Shiller P/E of 20+ for the S&P 500, provided I can diversify currency and revenue exposure. Our friend Mebane Faber has provided recent Shiller P/Es for many foreign markets here.

�A fine solution for owning foreign stocks without undo exposure to a particular currency is through FPA International Value Fund FPIVX . Its 1.35% expense ratio isn�t cheap, and it has only a one-year track record. But its 28% one-year return through December 14 lands it at the top of investment researcher Morningstar�s foreign value fund category and comfortably ahead of the 20% return of the MSCI EAFE Index over the same period.

Moreover, fund manager Pierre Py comes with good experience from another venerable value shop, Harris Associates. The fund has almost half its assets in stocks domiciled in developed Europe, but diversifies its currency exposure so that no one currency dominates.

Finally, the fund has little exposure to highly levered companies, and almost 30% of its assets in cash as Py waits for better prices. This young fund looks like it has the potential to be every bit as good at downside protection, while keeping up enough on the upside, as its all-star U.S.-oriented sibling, FPA Crescent Fund FPACX �.

John Coumarianos is a managing member of Hamilton Research and Management, an investment advisory firm in Northvale, N.J.