Is The Stock Market Overvalued?

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Harry Mamaysky floor plan picture


  • Looking astatine a 150-year history of nan cyclically-adjusted price-to-earnings (CAPE) ratio of nan S&P 500 scale suggests that nan banal marketplace is very overvalued.
  • However, this study ignores that net coming are not nan aforesaid arsenic net from 150 years ago. Adjusting for these differences makes nan marketplace overvaluation look overmuch little dramatic.
  • Furthermore, liking rates, while considerably higher than past year, are still comparatively debased by humanities standards. Adjusting for this makes stocks look very adjacent to reasonably valued.
Wooden seesaw standard quiet connected woody sphere connected wood array pinch wording VALUE and PRICE balancing


The Cyclically-Adjusted Price-to-Earnings Ratio

There are galore perspectives connected nan mobility of whether nan banal marketplace is overvalued. In this article, we look astatine 1 measurement successful particular, nan Campbell and Shiller cyclically-adjusted price-to-earnings ratio (CAPE). The CAPE ratio looks astatine the ostentation adjusted value of nan S&P 500 scale comparative to nan past 10-year mean of inflation-adjusted S&P 500 earnings. The use of averaging net is that this makes nan CAPE ratio overmuch little delicate to cyclical fluctuations successful firm earnings, which thin to hap correct astir each economical downturn. You tin download nan CAPE ratio and spot explicitly really it is calculated from Robert Shiller's website, arsenic good arsenic from different sources, for illustration nan NASDAQ information site for example.

Based connected nan existent worth of nan CAPE ratio, many argue that nan U.S. banal marketplace is very overvalued. Looking at nan CAPE ratio going backmost to nan 1880s shows that nan CAPE ratio is, indeed, precocious comparative to its semipermanent mean level of 17.6 (the orangish statement below).

cape plot1

CAPE ratio (QuantStreet, Robert Shiller's website)

The bottommost floor plan shows nan CAPE ratio comparative to its semipermanent mean value. Currently, CAPE is 12.8 points supra its semipermanent average, which is 1 of nan main information points underlying nan "stocks are expensive" narrative.

Are nan 1880s a bully benchmark for 2023?

One of nan implicit assumptions successful nan supra study is that nan investing world of nan late-1800s is simply a bully proxy for nan investing world today. But galore things person changed successful nan past 150 years. Three things successful peculiar whitethorn lend to today's value to net (P/E) ratios being higher, connected average, than P/E ratios from nan 1880s.

  1. First, it is imaginable that nan expected returns connected nan wide banal marketplace person decreased complete nan past 150 years. This 1 is difficult to refute definitively, but looking astatine realized banal returns complete 20-year periods does not propose that banal returns are little now than successful nan past (in fact, they look to beryllium higher).
  2. The net maturation of S&P 500 stocks whitethorn person accelerated since nan 1880s. This would consequence successful higher P/E ratios done nan elemental algebra of banal prices being adjacent to expected early dividends divided by discount rates minus anticipated maturation rates (i.e., D/(r-g) aliases nan dividend discount model). Looking astatine nan chart below, it surely looks for illustration nan per-share net maturation of nan S&P 500 scale has accelerated successful nan past respective decades comparative to nan early portion of nan sample.
  3. The different awesome difference, while a spot of a wonky accounting issue, is really really important. Tangible finance by companies (e.g., buying a printing press) shows up arsenic an plus connected nan equilibrium sheet, and does not correspond a deed to earnings. But intangible investment, for illustration a firm's repository of machine programs, does not show up arsenic an asset, and is charged against earnings. As nan system moves distant from tangible to intangible capital, firm net mechanically shrink because of nan differences successful this accounting treatment. Morgan Stanley has a good piece connected this. So today's net whitethorn conscionable beryllium systematically understated comparative to nan net of 150 years ago.
log eps

Log existent net of nan S&P 500 scale (QuantStreet, Robert Shiller's website)

Adjusting for differences

It is, of course, difficult to exemplary each of nan disparate influences that mightiness render 1880s net and P/Es different from those of 2023. One "trick" is to cheque whether nan clip bid successful mobility (i.e., nan CAPE ratio) has what economists telephone a time trend. A clip inclination reflects nan anticipation that a peculiar bid whitethorn beryllium steadily expanding aliases declining complete a agelong play of time. The pursuing floor plan repeats nan 1 we saw earlier, but alternatively than assuming a changeless CAPE ratio complete 150 years, nan chart shows nan clip inclination successful nan CAPE ratio. The clip inclination is nan champion fitting consecutive statement to nan CAPE ratio truthful that nan peaks supra nan statement and those beneath precisely offset.

cape 2

CAPE ratio pinch clip inclination (QuantStreet, Robert Shiller's website)

The first study is that location is simply a chopped clip inclination successful nan CAPE ratio complete nan past 150 years. This effect is highly statistically and economically significant. The mean level of CAPE successful nan 1880s was conscionable complete 10, and it is now complete 20 (actually 23.9). Will this mean level of CAPE autumn backmost to its low-teens level from 100+ years ago? For nan reasons already discussed, to america this seems unlikely.

Second, nan bottommost sheet of nan floor plan shows that nan existent CAPE ratio is still precocious comparative to nan semipermanent trend, but nan quality is now 6.4 points, precisely half of what we saw successful nan first type of this analysis.

What astir liking rates?

Recalling that a very elemental exemplary for banal prices is that they adjacent D/(r-g), that is nan expected early dividend divided by nan discount complaint minus nan expected maturation rate, changes successful liking rates, via their effect connected nan discount complaint successful nan supra formula, whitethorn besides effect nan P/E ratio of nan banal market. Lower liking rates should beryllium associated pinch higher P/E ratios. We now modify nan supra study to widen our inclination exemplary to besides return into relationship nan existent level of 10-year Treasury rates. As nan adjacent floor plan shows, while liking rates are now higher than a twelvemonth ago, they are still rather debased by humanities standards.

10-yr rates

10-year Treasury yields (QuantStreet, Robert Shiller's website)

Taking into relationship nan existent level of liking rates produces our 3rd and last study of nan CAPE ratio. The orangish statement below, superimposed connected nan bluish CAPE ratio, shows nan level of nan CAPE ratio implied by both nan clip inclination successful nan CAPE ratio and nan current, comparatively low, level of liking rates.

cape 3

CAPE ratios and model-implied CAPE ratios (QuantStreet, Robert Shiller's website)

The bottommost sheet of nan floor plan shows nan existent CAPE ratio minus nan model-implied CAPE ratio, wherever nan exemplary takes into information nan clip inclination and nan existent level of liking rates. The CAPE ratio is still higher than nan fair-value CAPE ratio level (of 26.3) but nan quality is now down to 4 points. This represents a small spot of overvaluation of nan U.S. banal marketplace comparative to its 150-year history, but nan overpricing is overmuch little melodramatic than nan earthy CAPE ratio would suggest.

How is this possible?

When you are bombarded by warnings of nan imminent demise of U.S. stocks, conscionable support successful mind that comparing today's CAPEs to those of 150 years agone is really an apples-to-oranges comparison. There are 2 competing hypotheses here. One -- nan last day presumption -- argues that nan marketplace is skating connected an irrational plateau of overvaluation, a bubble judge to beryllium imminently pricked. The different presumption is that things alteration complete time, and that these changes person led to permanently higher mean CAPE ratios than those that prevailed successful nan past.

Which position is correct? Only clip will tell. Our money is connected nan permanently higher CAPE hypothesis.

As always, investors should make judge to position their portfolios successful statement pinch their ain consequence tolerances and liquidity needs.

This article was written by

Harry Mamaysky floor plan picture

Harry Mamaysky is simply a professor astatine Columbia Business School and is nan CIO of QuantStreet Capital. QuantStreet implements quantitative plus allocation solutions for its clients. All articles I people are for acquisition purposes only and do not incorporate legal, tax, aliases investing advice. I urge consulting pinch the  due master earlier making legal, tax, aliases investing decisions.

Disclosure: I/we person a beneficial agelong position successful nan shares of VOO either done banal ownership, options, aliases different derivatives. I wrote this article myself, and it expresses my ain opinions. I americium not receiving compensation for it. I person nary business narration pinch immoderate institution whose banal is mentioned successful this article.

Editor: Naga

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