If you are a long-term investor, holding your retirement nest egg in a diversified portfolio of US stocks, perhaps in an IRA or 401(k) plan, experts and the facts now suggest that your retirement assets are probably substantially over-valued in today’s stock market.

Many equity investors are not nearly as well off as they think — unless they are in the process of selling out today to invest in fixed income securities and a widely diversified portfolio of real estate income properties.

The question that long-term investors should be asking is how much do they risk losing by continuing to believe in the Common Stock Legend and the advice of their stockbrokers?

In the roar of Wall Street cheering about good times for equities, the chances that most equity holders will ask sensible questions about market values in time to save their assets is remote.

And, if and when they should ask, it will certainly be too late, because stock markets are not designed to withstand a rush for the exits.

Quantifying the downside risk in equities

It is possible to find serious researchers at prestigious universities and financial experts with articles in the Financial Analysts Journal that state that a fall of 30% to 50% from current market levels would be required for US equities to be ‘fairly priced’.

This means that that wealth held in US equities is probably over-valued by $3.3 trillion to $5.5 trillion! A readjustment to fair value would be painful, with serious economic and political consequences.

See: “Are GAO Projected Returns on Equities Reasonable?“

Most investors do not have the time, inclination, or skills to plow through the technical literature to find out whether stocks are over-priced. And the SEC will not help them.

However, investors do not need to rely on articles in Money magazine (supported by ads of Wall Street firms), or the Quicken ‘retirement planner’ (based on assumptions that the past predicts the future), or even on their stockbrokers (who earn a living by selling common stock and equity mutual funds).

By using common sense and some easily available statistics, John Burr Williams’ famous formula for equity valuation allows investors to check for themselves whether US equities, in general, are fairly priced or not.

As John Burr Williams pointed out seventy years ago, the sensible reason for long-term investors to hold common stocks is to receive a future stream of dividends paid by the company.

To build up wealth for their retirement, investors should put aside enough current income to provide for their old age, reinvesting dividends and interest received in the interim.

A prudent retirement plan: the essentials

No one can predict what the marketplace may be willing to pay for equities twenty or thirty years from now, when today’s retirees will need to sell investments.

However, with the anticipated crush of Baby Boomers needing money for assisted living and health care ten to twenty years from now, chances are good that ‘reinvesting unrealized capital gains’ in the hope of selling out many years from now is, at the very least, unwise.

A sound retirement portfolio is one that will throw off a dependable stream of cash dividends and interest, not only to provide income decades from now, but also to provide substantial current yields at that distant date so as to ensure that the value of a retirement portfolio is supported by cash payouts, so that, if it is necessary to draw down on the principal, the portfolio will be fully valued by the market.

Why US equities are 40% over-valued today

Here is how an investor might evaluate the level of US equity prices, based on John Burr Williams’ formula:

 

Input values of formula	Value
G= Dividend growth rate (based on S&P 500 dividends for period 1985-2006)	5.5%
I= Typical expected return for equity investments by American retirees	8.0%
John Burr Williams’ formula for evaluating one dollar of dividends	D/(I-G)
What current dividend yield should be, based on John Burr Williams’ formula	2.5%
Actual current dividend yield, based on S&P 500 (2006) stocks	1.77%
Market fall required to adjust S&P 500 current dividend yield to 2.5%	29.2%

See “The Value of Dividends” for an explanation of John Burr Williams’ formula.

 

In other words, given the S&P 500 rate of growth of dividends on US equities over the last twenty years, and popular expectations of return from long-term portfolios of common stocks (about 8%), equities, on average, seem to be over-priced by about 40% based on the current value of reasonable expectations of the future stream of dividends.

Considering that the annual growth of before tax US corporate profits over the long-term (1946-2003) was only 5.3%, predicting growth of corporate dividends at 5.5%, based on the S&P 500 dividends from 1985 to 2006, certainly does not seem to be overly-conservative.

So the two numbers needed for John Burr Williams’ equation, the 8% return expectation of investors and a 5.5% growth rate for dividends, seem to be quite reasonable.

Therefore, a drop of about 30% in stock prices would be required for equity investors to get the 8% return most expect when planning to fund retirement goals.

Corporate reform could dramatically improve equity values

Although, as indicated in the article “US Equities: Wildly Over-Priced or a Great Bargain?“, corporate earnings before buybacks are soaring to record levels, a huge multi-billion dollar chunk of this money is being diverted to the benefit of corporate executives rather than long-term shareholders.

If Corporate America were to suddenly reform, putting brakes on executive remuneration and redirecting buyback payouts into cash dividends, paid out fairly to all investors, then, indeed, Wall Street ballyhoo would be justified. Equities would be fairly valued and ordinary investors would be adequately protected.

However, since buybacks and corporate greed seem to be embedded in Wall Street culture, any investor who is willing to bet his or her retirement comfort on a sudden change of heart and sincere reform of rapacious executives, may deserve to be taken to the cleaners.

Expect continued irrational behavior

As pointed out in a previous article, if US corporations were to change their behavior, eliminating stock buybacks and using the money instead to pay dividends fairly to all shareholders, US equities would indeed by fairly priced and most retirement plans would be on track.

However, don’t hold your breath until that happens.

Uncontrolled, self-serving behavior of corporate executives taking advantage of an accommodating and dormant SEC and the unquestioning belief of the investing masses in the Common Stock Legend suggests that current patterns are likely to persist and that, therefore, US equities will continue to be substantially over-priced — until the next crash.

In a recent study of the effect of the retirement of Baby Boomers on the price of equities, the GAO based its conclusions on the assumption that equities will provide real returns of over 7% over the next decades, stating:

“Returns on investment are important in helping many Americans accumulate sufficient savings throughout their working lives to meet their retirement needs. From 1946 to 2004, U.S. stocks have returned an average of 8.0 percent annually, adjusted for inflation.”

“According to a recent study surveying the literature, such simulation models suggest, on the whole, that U.S. baby boomers can expect to earn on their financial assets around half a percentage point less each year over their lifetime than the generation would have earned absent a baby boom.”

The GAO conclusions were dependent upon investors earning at least 7.5% per year on equity holdings, after inflation, for the foreseeable future.

Is this projection reasonable and is it based on fact?

And, why is this important?

Where Expectations of Market Returns Come From

The $14.9 trillion market value of US domestic equities (Q1 2006) is predicated upon common expectations of future returns on stock investments. The GAO figure of between 7 and 8% (real returns) is representative of current market consensus.

If this general expectation were to be significantly reduced, a loss of several trillion dollars of market value would almost inevitably follow. Holders of US equities would become much poorer should there be a substantial reduction in commonly projected long-term returns on equities.

A reduction in this widely-accepted projection would also impact heavily on defined-benefit pension funds and the savings plans of millions of households.

So how is it that millions of investors have come to believe that investing in stocks will produce long-term real returns of over 7% per year? After all, no one knows what the future holds.

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In a major exposé of misused executive options, the Wall Street Journal ran a front page article on July 15, 2020, entitled:

“Executive Pay: The 9/11 Factor; As stocks sank after the attacks, scores of companies rushed to issue options to top officials. Some reaped millions.”

Wall Street Journal research showed that:

1. From September 17, 2020 to the end of that month, 10% of leading public companies issued stock options to 511 top executives;

2. The number who received grants was 2.6 times greater than the same period of September 2000, and more than twice as many as in the like period in any other year between 1999 and 2003.

3. Almost half of the companies issuing options during this period, did not normally issue stock options in September.

4. Most grants were concentrated around September 21st, when the market reached its post-attack low.

The Wall Street Journal went on to say:

There’s nothing illegal about granting options after the market plunges. But acting so quickly after a national tragedy drove down stocks shows the eagerness of some companies to increase their executives’ potential wealth.

Stock options were originally designed to align executives’ incentives with the goals of shareholders, encouraging recipients to work hard to improve their companies’ stock price. When these options are granted at favorable prices, executives get some of their gain free — that is, they are buying at an unusual dip below the price most investors have paid.

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