The Globe and Mail, Report on Business
Published October 29, 2010

Whenever one investment theme, strategy or person is in the spotlight, it’s important to look in the shadows for a different perspective. That’s because as voices get louder and more confident, a consensus emerges that makes it harder to find the counterpoint.

Right now, the economists have the stage (“It’s all about the macro”) and the most bearish ones are hogging the podium. As much as anyone in the world, my fellow Globe columnist David Rosenberg, chief economist and strategist at Gluskin Sheff, has been responsible for forging the current consensus. He believes we’re heading into a sustained economic slump and perhaps another recession. His 2011 earnings estimate for the S&P 500 is $75 (U.S.), well below Street estimates of $95.

As a result, Mr. Rosenberg is bearish on stocks. In a column earlier this month he multiplied his $75 estimate by a price-earnings multiple of 10 to arrive at a 750 target for the index, far below its current level around 1,184. He picked a 10 multiple because it’s “consistent with the prevailing economic uncertainty.”

In search of market perspective, I started by pulling out my trusty Morningstar chart that shows returns for one-, three-, five-, 10-, 20- and 30-year periods going back to 1950. As you’d expect, the range of one-year returns for the S&P 500 (in Canadian dollar terms) is wide, stretching from minus 40 per cent (for the period ended September, 1974) to plus 56 per cent (July, 1983).

As the time frame is extended, however, the ranges narrow considerably. For the 10-year period ended June 30 of this year, Canadian stocks, U.S. stocks and Morningstar’s hypothetical balanced portfolio (10 per cent cash, 30 per cent bonds, 60 per cent stocks) are all right at the bottom of their historical ranges at plus 3 per cent, minus 5 per cent and plus 2 per cent respectively (compounded annually).

The chart tells us that stock markets have just gone through one of the worst 10-year periods in history and prices are already reflecting some bad economic news.

The next stop on my search for perspective was the valuation tables. This critical element of investing is always tricky. When looking at price to earnings multiples (P/Es) for instance, we know the numerator to the penny (stock prices), but the denominator (earnings) is an estimate that moves around.

Nonetheless, it strikes me that Mr. Rosenberg and others in his camp are doubling up on the pessimism. They’re multiplying a conservative earnings estimate by a rock bottom P/E multiple – a 10 multiple is near the bottom of the historical range. My research suggests that P/Es are at worst in normal territory and at best significantly below where they should be. I’ve had portfolio managers tell me that valuations are just “okay,” but also had enthusiastic endorsements peppered with words like “screamingly cheap” and “getting paid to take risk again.”

Certainly valuations are dramatically different compared to the start of the last lost decade. If we flip P/Es over to create what is called earnings yield, the comparisons are stark. In 2000, earnings yields were 3 to 5 per cent at a time when bond yields were 5 to 6 per cent. Today, earnings yields are 7 to 9 per cent while bonds are yielding just 2 to 3 per cent.

The other area where it’s important to maintain a balanced perspective is investor sentiment. In this regard, it’s clear that the consensus view is a gloomy one. Mr. Rosenberg isn’t one to run with the herd, but whether he likes it or not, the herd is running with him.

The bears may prove to be right on the economy, but we have to remember that it’s tough to make money by betting with the consensus. If everyone is looking one way, the opportunity to generate over-sized returns often lies in another direction.

As I’ve said before, I’m not optimistic about what lies ahead for jobs, housing prices, GDP growth and corporate profits (yes, I’m in the middle of the herd in this regard). But I’m not so quick to translate that view into another lost decade for stocks. We’re starting from a very different place. Valuations are dramatically better and the average investor is underinvested.

I have no idea where the bond and stock markets are going in the next few months, or even the next year or two. But from my position in the backstage shadows, it looks like stocks are going to beat bonds by a substantial amount over the next decade.