Will We Lose Our “Stocks for the Long Run” Religion?

Despite all the doom and gloom seen over the last year, the S&P 500 index is still looking expensive. At Friday’s close the benchmark index traded at a Price to Earnings (P/E) ratio of 24.30, much higher than the 17.17 ratio seen a year ago when the downturn started. FYI – the long term average P/E ratio for the S&P 500 is around 15. With some commentators proclaiming that we are facing the greatest crisis since the Great Depression, why do stocks remain expensive?

Most commentators talk about index construction when explaining this anomaly
, but I’d like to offer a different explanation: Investors continue to believe that stocks will do well in the long-term. They see the current stock market meltdown as a buying opportunity, supporting stock prices and inflating P/E ratios. "Buy when there is blood on the street!" goes the chorus.

It is dangerous to automatically assume that stocks will continue to do well. Merrill strategist Richard Bernstein recently pointed out that cash has outperformed stocks for the past 10 years. "If this grim reality continues, the abysmal performance will eventually cause investors to lose faith in the "stocks for the long run" religion that developed during the 1990s," writes Henry Blodget at ClusterStock.

The fact that the S&P 500 P/E ratio remains high during a meltdown might indicate that investors have not yet given up on the "stocks for the long run" religion. I will be the first to admit that this is an overly simplistic explanation, but it raises an important question we should not ignore: If the financial planning profession, e.g. mutual funds and CNBC talking heads, tell you that the stock market is a good long-term investment, should you believe them? I’d like to quote Doug Wakefield, the president of Best Minds:

"The financial planning profession, as represented by the College for Financial Planning, only came into existence in 1972, which is to say, the vast majority of investors and advisers have built their investment capital during the largest bull market in U.S. history," writes Wakefield. "So, the majority of today’s investors and advisers’ only experience with a bear market was that which occurred from 2000 to 2002, which was “solved” by the lowest interest rates and the largest amount of credit (debt) ever in U.S. history, which created no incentive to change one’s business model from that of the bull market boom."

In other words, the financial planning profession’s business model has never been tested in a long-term bear market. Reluctant to change their business models, they will probably continue to preach the "stocks in the long run" religion. But why should we continue to believe in their dogma? Just because stocks did well over the last 30 years does not mean they will do well over the next 30 years.

Disclaimer: I own SDS and DXD (ultra-short U.S. equities)