Are Stocks Overvalued?

The U.S. stocks indexes are about 150% or more above their lows of 2009. That recovery is increasing the number of people worrying that stocks are too highly valued or even in a bubble with two 50% or greater declines occurring since 2000, people are more on the lookout for big declines than they were 15 years ago. The strongest argument of bearish investors is the high valuation of the CAPE or Shiller P/E ratio. This ratio uses a 10-year average of corporate earnings, adjusted for inflation, to measure an index’s valuation. Using a 10-year average takes out fluctuations due to market cycles and corporate special earnings items. The CAPE is somewhat close to its all-time high levels, well above its long-term average, and just below levels reached near the last two big market declines.

But have things changed enough that call into question the usefulness of the measure today. Jeremy Siegel of the Wharton School wrote an article for The Financial Times that was  preview of a presentation he gave a few months later. The article raises several questions about the measure. He says the rules for reporting corporate earnings changed in the 1990s, and the change was significant enough to affect long-term comparisons. Other changes in earnings include the low interest rates corporations pay today, the large percentage of corporate debt that it long-term now, and the higher percentage of foreign sales (which tend to have higher margins). Because of these factors, Siegel believes the stock indexes are not as highly valued as the CAPE ratio indicates.

The bullish case for equities relies not only on the expectations of higher earnings but also on the possibility that P/E ratios will expand significantly. It is a historical fact that low inflation and low interest rates translates into higher P/E ratios.

Since 1954, whenever long-term interest rates have been below 8 per cent, the P/E ratio of the S&P 500 Index has averaged 19. Real interest rates (and hence yields on inflation-linked Treasury bonds) are strongly tied to GDP growth and if the “new normal” growth pessimists are right, real interest rates are unlikely to rise above 2 per cent. Even if inflation runs somewhat above the Fed’s 2 per cent target, nominal rates on Treasury bonds will rise to at most the 5 per cent level, below the zone where P/E ratios contract.

Long-term real returns on stocks are strongly linked to their “earnings yield”, which is the reciprocal of the P/E ratio. It is not a coincidence that the historical average P/E ratio for stocks of 15 yields an earnings yield of 6.7 per cent, extremely close to the 6.6 per cent historical real return for stocks.