Five Good Questions for LPL's Jeffrey Kleintop

The chief investment officer shares his views on the markets, Occupy Wall Street and more

Jeffrey Kleintop serves as executive vice president and chief market strategist of LPL Financial, where he establishes market forecasts, helps define the tactical allocation used to help manage $77 billion in assets, and authors several flagship research publications, including weekly market reports and white papers on investment decision making.

As a nationally recognized strategist, Kleintop is regularly sought after to speak to the national media—including Bloomberg, CNBC, and Fox Business—as well as at financial advisor and financial services industry events. He was featured in the Wall Street Journal article “Wall Street’s Best and Brightest” and was called “One of Wall Street’s best long-term thinkers” by The New York Times. Kleintop is the author of the popular investment book Market Evolution: How to Profit in Today’s Changing Financial Markets, which was published in 2006.

Prior to joining LPL Financial in 2007, he served as chief investment strategist at PNC Financial Services Group for seven years. At PNC, he helped define the asset allocation and portfolio strategy for over $50 billion in assets under management, served as vice chairman of the investment policy committee, and was co-portfolio manager for $10 billion advantage portfolios of large-cap growth, value, and core U.S. stocks. Prior to PNC, Kleintop served as senior investment analyst at Aris Corp of America, where he was instrumental in founding the registered investment advisor program that grew, within five years, from a small local firm with $300 million in assets into a regional asset manager with nearly $2 billion under management.

Kleintop has a Bachelor of Science in business administration and finance from the University of Delaware and an MBA in finance from Pennsylvania State University. He is a Chartered Financial Analyst and is Series 7, 65, 86, and 87 registered. I am pleased that Jeff has agreed to answer what I hope are Five Good Questions.

1. Back in July, you anticipated a rally over the second half of 2011 and recently confirmed that view.  Why hasn’t that happened (at least so far) and what do you expect today?

We continue to subscribe to the forecast we have held all year for modest single-digit gains for the stock market.  We believe the gap between feelings and facts got too wide with pessimistic investors failing to notice solid economic and profit reports and progress dealing with the challenges in Europe. 

October, often the month that declines end and rallies begin, has brought the rally back to positive territory on the year for the major indexes.  Having experienced a powerful double-digit rally from the lows, we anticipate modest additional gains accompanied by volatility for the remainder of the year as the markets end the year in line with our forecast.

2. The best measures we have of forward-looking long-term return projections for the equity markets, what I call “leading investment indicators” (PE10, dividend yields, Q, market cap-to-GDP, interest rates), are very negative.  How do these measures impact both your long-term and nearer-term forecasts and expectations?

We believe that history has made it clear that the most consistently accurate predictor of long-term stock market returns is the S&P 500 price-to-earnings ratio (P/E).

The P/E is obtained by taking the price level of the index and dividing it by the earnings per share over the past four quarters. Essentially, the P/E is how many dollars investors are currently willing to pay per dollar of current earnings.

The level of the P/E and the annualized return on stocks over the next 10 years have a very close relationship.  In essence, the lower the P/E, the higher the return over the next 10 years.  Currently, this relationship predicts that high single-digit gains are likely, on average per year, for the stock market over the next 10 years. 

Despite the fact that the P/E has a nearly perfect track record of forecasting long-term performance, many have been selling and believe that it is different this time given the troubled banks, European credit problems, geopolitical tensions, concerns over both inflation and deflation, the U.S. budget deficit, threat of rising tax rates, and uneven economic data, among other concerns.

We do not dismiss these issues.  However, the P/E has demonstrated consistent success predicting long-term returns over the entire history of the S&P 500 index—going all the way back to the 1930s! 

Investors have always faced challenges. Since 1928, the S&P 500 has weathered massive bank failures, a dozen European countries defaulting, world war, double-digit inflation, top marginal income and dividend tax rates of about 90 percent, the percentage of U.S. government debt-to-GDP at double the current level, not to mention the Great Depression.

And yet, through all of these unprecedented events the P/E remained a consistently accurate forecaster of future long-term returns.

The annualized loss for stock market investors during decade of the 2000s was the result of the record high 30 P/E 10 years ago in early 2000. However, we believe the current P/E of about 12 forecasts a better decade for performance ahead. The current P/E of around 12 suggests a 7-8% price return for the S&P 500.  The addition of a 2% dividend yield may result in a total return of 9-10%. 

Based on this relationship between future returns and P/E, the stock market’s lowest valuations in 20 years suggests this is the best time in 20 years for long-term investors to be buying, not selling, stocks.

By way of contrast, the point of PE 10 (the CAPE) is to make an explicit adjustment in the calculation for the business cycle.  Perhaps, but smoothing valuations over 10 years is not the best way to do that. Looking at the average of the last 10 years of prices makes little sense to me.  You pay today’s price when you buy – not the 10-year average.  

Go to the gas station and try to pay the 10 year average for your gasoline and see what happens.  It doesn’t make sense. In addition, the S&P 500 index has had a tremendous amount of turnover in the past 10 years.  I don’t think what Lehman earned in 2004 matters to S&P 500 valuations today. 

But most importantly, the trailing PE has a nearly perfect track record of forecasting stock market performance over the next 10 years – the 10-year PE does not. 

It worked in the Great Depression, it worked in World War II, it worked in the inflation spiral of the 1970s, it worked in the booming 1980s and 1990s and it worked in the past decade.

3. Are the Efficient Market Hypothesis and Modern Portfolio Theory on life support or even dead?  Why or why not?

I often refer to Charles Darwin’s statement from On the Origin of the Species when it comes to what is most important to investment survival in today’s markets: “It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.”

Investors face a challenging environment today. The drivers of investment performance are undergoing an evolutionary change that is resulting in volatile and below-average financial market performance. Such conditions place a premium on adaptation and innovation, and make proactive investment decision making more valuable than ever. A new portfolio framework is necessary to exploit opportunities and achieve performance goals.

In the environment that confronts investors over the coming years, an adaptive approach to investing is likely to prove to be more valuable than the static models proposed by out -of-date theories.  Incorporating themes into investing is more important than ever.  And remember, that with the price you pay so important to long-term performance, taking advantage of market volatility to seek opportunities can be very valuable and may result in returns in excess of those offered by static indexes.

4. You have argued that the 2012 election is a big one for investors – why do you think so?

The 2012 election is likely to be consequential for investors.  There is a growing consensus that a plan to save about $4 to 5 trillion over the next decade is necessary to stabilize the debt-to-GDP ratio in the United States. Despite the efforts of the “super-committee” tasked with finding the $1.5 trillion agreed to in the terms of the debt ceiling deal crafted in early August, a package this size is unlikely to become law before the election.

Since congress is unlikely to pass a major deficit reduction bill before the 2012 election, the outcome will have major implications for investors.  The party to emerge in control will forge the decisions that will represent one of the biggest shifts in the federal budget policy since World War II.

Failure to pass a major deficit reduction package, regardless of what the rating agencies do, will likely result in investors loss of faith that the federal government get on a fiscally sustainable path absent a financial crisis.  Of course, this loss of faith would help to produce the crisis, with major implications for the markets, and force a major deficit reduction deal.

Regardless of the details of the plan – and we have many proposals to choose from that blend a mix of tax increases and spending cuts – most proposals phase in the impact so that it isn’t until five years from now that the full impact would be felt.  The cuts would likely be equivalent to about 3% of GDP, or about 14% of the federal budget.  This would be one of the biggest policy shifts in modern U.S. history. 

While the markets may welcome a resolution of the uncertainty and a path to fiscal sustainability, certain sectors may feel the brunt of the cuts, such as health care and the defense industry.  Other asset classes may be impact as well if changes are made to the tax advantaged status of municipal bonds for some tax payers.

As we look out to the next few years, the old adage that the market likes “gridlock” or balanced government between the two parties may not hold. 

It is apparent in recent market performance that investors recognize that substantial, defining fiscal policy changes – difficult to forge in a divided congress - are needed.  Based on polling data it appears that the GOP may retain control of the House and gain control of the Senate, by a small margin.  Having both houses of congress in the hands of one party increases the odds of significant policy actions.

5. What do you make of the Occupy Wall Street phenomenon, which claims that Wall Street has been cheating rather than winning?  Are some major changes desirable and, if so, which ones?

The core of the protest movement appears to be driven by a sense that only a few are succeeding while many are falling further behind as personal income lags inflation and the unemployment rate remains stubbornly high. 

We anticipate private sector employment growth to be 150,000 to 200,000 per month over the next 12 months.  This is likely not enough to bring down the employment rate materially and may sustain the protest movement over the next year as we approach the next election.

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