Lee: Forvent lavere avkastning i USA, noe høyere i vekstmarkeder

Sam Lee: Pleasure to be here.

Glaser: Let's talk a little bit about how you think about market valuation generally. What are some of the metrics that you look at to figure out if the market looks expensive or cheap?

Lee: My favorite metric by far is the Shiller P/E, or the Shiller price/earnings ratio. And it's very simple. All it does is it takes the 10-year average of earnings. inflation-adjusted. and divide it by current price. And what this tells you is, what is the market's underlying fundamental earnings power. And it smoothes out the effects of the business cycle; business cycles can range anywhere from five to seven years.

I think it's a very elegant way of measuring it. It's actually not invented by Robert Shiller, the Yale University economist who recently won the Nobel Prize. It was actually first proposed by Benjamin Graham and David Dodd all the way back in the 1930s. This is a very old idea, but it's one that, I think, has stood the test of time.

Glaser: What's the Shiller P/E telling us right now? Where does it stand versus historical averages?

Lee: The Shiller P/E recently hit 25. When you invert that you get is another measure that I like: the cyclically adjusted earnings yield. The inverse of the Shiller P/E, 1 divided by 25 is about 0.04, or 4%. And this is the smooth earnings yield of the market. This is actually, I think, a reasonable forecast for what the market can be expected to return during the next 10, 20 years. And a 4% real expected return is well below the historical average of 6.5%.

The Shiller P/E is saying that the market is overvalued relative to history, that you can expect about 2 percentage points less per year over a long period of time.

Now, whether that's overvalued or undervalued depends on what you believe about the market. People assume that because the Shiller P/E is 25 right now, and the long-term average of Shiller P/E is 16, that the market is way overvalued, 50% overvalued or so. And I don't think that's necessarily the case because the market's valuation also depends on prevailing interest rates.

Right now, interest rates are extremely low, and the bond market expects interest rates to stay low as far as the eye can see. And if you believe this is true, then the market's current valuation is actually quite reasonable because the spread between what you can get in bonds versus what you can get in stocks is still around the historical average, about 4 percentage points.

But if you don't believe that the bond market is right, that interest rates will stay low as far as the eye can see, that interest rates will somehow revert to the mean, then the stock market doesn't look so attractive. This is because when bonds start going up and their interest rates start offering competitive yields with the market, the market has to lower its price to bring its earnings yield up. It's really a question of what do you believe about interest rates. Ultimately, I think the stock market is still implicitly a bet on interest rates.

Glaser: [Looking at the] Shiller P/E then, it doesn't seem like we are on the precipice of another 50% decline or the kind of valuation levels we saw in [2000] going into the financial crisis?

Lee: Certainly not. Then the Shiller P/E hit the 40s, and we are nowhere near that level. The Shiller P/E has historically been consistent with a very wide range of returns. The market at the Shiller P/E has gone on to return close to 10% real over the next 10 years, and it's gone on to lose several percentage points annualized over the next 10 years. So there is a very wide range of uncertainty.

But the average return has actually been about close to zero over the next 10 years. So if you believe that the market is mean reverting to its historical Shiller P/E, and that the past is a reasonable guide to the future, then you can expect lower returns than the naive 4% forecast return that I provided.

Glaser: How about any other models that you look at. That's obviously one way to look at the market. Are there other ways that you keep an eye on things?

Lee: Another one is the Gordon Dividend Growth Model. So the market grows its dividends at a pretty consistent rate. It doesn't vary more than a couple of percentage points. If you take the market's current dividend yield and you add some kind of historical average dividend growth rate to it, you actually get a pretty good idea of what you can earn over the next 10 to 20 years.

The market yield is about 2 percentage points right now, a little under that. But dividend yield is actually a bit misleading because over the past 30 years, companies have turned more to share buybacks, so net share buybacks add maybe 0.5 percentage points to current yield. So that's 2.5%. And historically the per-share dividend growth has averaged about 1.5%. What you're looking at it again is a 4%-per-share real expected return for the market from this perspective. It's actually quite similar to the Shiller P/E forecast.

And I think this is actually quite a good future because you don't want a valuation metric to say something wildly different from another one; that suggests that somehow your valuation model is broken. So the Dividend Growth Model and the Shiller P/E tend to say the same things right now.

Glaser: If we are potentially looking at this 4% return type of environment or maybe lower than people have gotten used to, what are the investment implications of that? Is it that you should maybe think about reducing your stock exposure, or does it really depend again on that interest rate or your thoughts on interest rates?

Lee: We are going into the realm of market timing. This is a very dirty word. And I think it is justifiably a dirty word because the market's average return has historically been so high that attempts to time it have been very punishing.

So, right now the Shiller P/E and even the Dividend Growth Model aren't screaming "Get out of the market right now." For me it is uncomfortable, but it is not at the level where you should say, "I am going to pull all my cash out of the market." That I think is very foolish.

What it does say, I think, is that you should moderate your expectations for what's going to happen in the future and that maybe on the margin you should reduce some of your U.S.-equity risk exposure.

Glaser: But if you are looking to, on the margin, reduce your U.S. upgrade exposure, where is there to go? What other asset classes maybe look a little bit better right now?

Lee: There is really nowhere to hide because interest rates are low worldwide. One place to look at is emerging markets. These are some of the most loathed countries right now. Everyone loves the U.S. because the U.S. has rallied tremendously over the past five years. Emerging markets rallied after the financial crises, but over the past three years they've been about flat. People tend to extrapolate the recent past into the future indefinitely. People think the U.S. is wonderful, rah-rah, and that emerging markets are ugly. "Look at China; it is going through a slowdown."

I think valuations for emerging markets are reasonably attractive right now, especially in relation to low interest rates. The MSCI emerging markets index yields about 3% right now, and if you believe that emerging markets will experience faster per-share real earnings growth--I think on the level of 3% is a fair bet--then you can expect something close to about 6% real over a long period of time.

Now, I have to caution that this forecast is actually a little bit iffier because a lot of it depends on what China is going to do. Some people say that China is in a massive credit bubble and that a lot of the earnings during the past decade have been driven artificially by it. I think there might be some merit to that, so you should maybe deduct a percentage point from this forecast. So, maybe 5% is a more reasonable expected return for emerging markets.

Glaser: Sam, thanks for your thoughts on valuation today.

Lee: Glad to be here.

Glaser: For Morningstar, I am Jeremy Glaser.