Five Good Questions for LPL's Jeffrey Kleintop

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.