Why I’m Concerned about Stock Market Valuation Levels

December 16, 2014

by Ron A. Rhoades, J.D., CFP®

 

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Looking at a range of valuation metrics, long-term investors have good reason to worry about the U.S. equity market. They can take comfort, however, in the fact that certain asset sub-classes are less overvalued that others.

There are many ways to determine valuations of individual stocks and then, by extrapolation, the levels of asset classes or the overall U.S. stock market. However, some measures, such as price-to-earnings (P/E) ratios, are highly volatile and can yield results that are nonsensical. The Shiller cyclically adjusted price-to-earnings ratio (CAPE) is a better way to determine value on the basis of earnings, given that earnings are smoothed over a decade. Still, various adjustments may need to be undertaken for this to produce reliable results. The Shiller CAPE is approximately 26, as compared to its historical mean of approximately 16; thus, it indicates approximately 50% overvaluation (see here).

Other measures of valuation incorporate interest rates using yields on U.S. Treasury bills, notes or bonds. While there is much intellectual support for this approach, one might question whether long-term investors’ approach to valuations should be so heavily influenced by interest rate yields. Over any 15-year period, yields can tremendously vary.

For over a decade, I’ve primarily relied upon price-book (P/B) ratios to provide me a sense of how overvalued, or undervalued, the U.S. stock market may be. For the Russell 1000 and 2000 indices (growth, balanced and value) I’ve been able to reconstruct an estimate of the average P/B ratio going back to 1977. This gives us 34 years of data to come up with an average. P/B ratios for Russell indices are provided monthly, giving us fairly up-to-date measures. Book values don’t fluctuate wildly over the short term.

Of course, there are downsides to the utilization of P/B ratios. Since 1977, the U.S. economy has moved away from capitalization-intensive industries (manufacturing) and toward service-sector industries. As part of this evolution, new industries like computer software and services have grown that are not very capital intensive. Many companies have outsourced their manufacturing to companies in China, the Philippines, Indonesia and other countries, thereby lowering their book equity. Hence, one can argue that the “mean” for price-book ratios should be higher than the 1977-2013 estimated average P/B ratio shown below.

Current (12/7/2014) valuations of U.S. stock asset classes are as follows, based upon price-book measures of these asset class relative to 1977-2013 norms, with further adjustments reflecting 11/1-12/5/14 returns:

ASSET CLASS

10/31/14 P/B Ratio 

P/B Ratio after 11/1-12/5/14 returns adjustment

1977-2013
Est. Avg. P/B Ratio

Percent Overvaluation / (Undervaluation)
Relative to Estimated Average P/B Ratios

Resulting Adjustment to Asset Class Historical Rate of Return

U.S. Large Cap Growth

5.26

5.42

4.0

35%

-2.1%

U.S. Large Cap Balanced

2.75

2.83

2.3

23%

-1.4%

U.S. Large Cap Value

1.84

1.89

1.6

24%

-1.4%

U.S. Small Cap Growth

4.11

4.15

3.2

30%

-1.8%

U.S. Small Cap Balanced

2.24

2.26

1.8

26%

-1.5%

U.S. Small Cap Value

1.54

1.56

1.3

20%

-1.2%

Source: Data based upon Russell Indexes for U.S. stock asset classes and Vanguard funds monthly/MTD data as accumulated and analyzed by ScholarFi Inc. All measures of overvaluation/undervaluation are estimates. An adjustment is then made to available month-end data, derived from Russell Index data site, for changes in prices over subsequent period to date shown.

The last column in the chart above reflects an adjustment to estimated average rates of return for the asset class should reversion to the mean occur over a 15-year time horizon.

Full article here