Are Stocks Overvalued? A Survey Of Equity Valuation Models by Research Affiliates
It should come as no surprise in one of the longest-running bull markets in U.S. history that the question “Are stocks overvalued?” is ever present in the minds of both investors and investment professionals. A Google search of this simple phrase returns 551,000 results, and an Amazon book search for “equity valuation” finds 3,411 listings. For better or worse, the topic is even periodically broached at the highest levels of the Federal Reserve:
I would highlight that equity market valuations at this point generally are quite high…. They are not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low, but there are potential dangers there.
— Federal Reserve Chairperson
Janet Yellen (2015)
[H]ow do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions…?
— Former Federal Reserve Chairperson
Alan Greenspan (2008)
An attempt to answer this deceptively simple question is aided by various equity valuation models and tools, all of which can be extraordinarily useful in estimating the expected long-term return of the market. These tools cannot consistently tell us, however, with any accuracy, when market prices will be heading up or down, although they may occasionally get lucky.
Figure 1, which shows a box plot of returns for the S&P 500 Index over different investment horizons, helps explain why this is the case.1 Take, for example, the five-year investment-horizon box. It shows the historical distribution of annualized returns for every five-year period in the history of the S&P 500. Notice that as the investment horizon increases from 1 to 10 years, the median return (i.e., the horizontal line across the center of the box) remains pretty stable, while the variance of returns narrows dramatically. Said another way, short-term forecasters must contend with a lot of uncertainty. Of course, given a large enough number of forecasts, based on a sufficiently broad set of indicators, a few short-term forecasts will eventually hit the mark, but in general, it’s a losing game. Thus, for those engaged in short-term forecasting, we can only say, “Good luck with that!”
We do not mean to imply that equity market valuation is a hopeless endeavor. On the contrary, over the long run it can be of enormous benefit to the patient investor. Just as with valuing individual companies, the tools we use to value entire stock markets fall into two categories. The first includes absolute valuation models that directly estimate expected returns by using an approximation of discounted cash flows condensed into a building-block type of model, such as the Gordon growth model.2 The second category includes relative valuation models based on price multiples that are compared against a steady-state level. Although we could write reams discussing every model and ratio that has ever been documented on equity valuation, we restrict our focus to the more popular metrics.
We use real returns in our analysis because returns after inflation are what build wealth.
Absolute Valuation Models
We begin with a discussion of the two absolute valuation models named in Table 1: Model 1, the average of dividend yield and earnings yield; and Model 2, dividend yield plus historical average real growth.
Model 1, the simple average of dividend yield and earnings yield, is a quick and easy method to calculate the expected return of the equity market. This model accounts not only for income received by investors, but also captures growth from reinvested earnings and recognizes historically documented share dilution (i.e., the difference between new share issuances and buybacks).
The short-term and long-term return forecasts of the U.S. equity market, using Model 1, are plotted in Figure 2. Recall that Figure 1 illustrates the much greater uncertainty of shorter term forecasts compared to longer term forecasts. Therefore, as we would expect, Figure 2 shows that over a one-year horizon the model has almost zero predictive power, with an R2 of 3%, but when the horizon is lengthened to 10 years, the explanatory power jumps to 31% (56% correlation).
As of June 2015, Model 1 forecasts the one-year U.S. equity yield to be 3.7%, the average of 5.4%, the trailing S&P 500 one-year earnings yield,4 and 2.0%, the trailing S&P 500 one-year dividend yield.
Model 2 is widely known as the dividend growth model. This model is based on the belief that dividend yields are constant over time; that is, equity prices rise in lockstep with cash flows to maintain a constant yield. The second input in the model, historical average real growth, can be neatly estimated using the recent historic trend in real earnings per share (EPS) growth. Long-term real EPS growth in the United States has been relatively constant at about 1.5% a year. Combining this value with the current dividend yield of 2.0% results in a forward one-year expected yield of 3.5%, not dramatically different from the return forecast by Model 1. And like Model 1, the dividend growth model is all but useless over a short time horizon, as is painfully obvious in Figure 2, but it does have merit at longer horizons.
Relative Valuation Models
The two absolute valuation models work well when yields remain constant, but in the real world prices can vary wildly around slower-moving fundamentals, such as dividends and earnings. As a result, it is also important to pay attention to relative valuations. Model 3 uses price divided by average 10-year real earnings, also called the cyclically adjusted PE ratio, or CAPE, to model expected returns. CAPE, or its inverse, the cyclically adjusted earnings yield plotted in Figure 2, captures equity prices relative to a smoothed economic anchor. Countless other relative valuation metrics relate prices to other anchors, and they all tell a similar story. We focus our attention on four of the most commonly cited, as listed in Table 1.
Converting each of these models into a return forecast requires comparing the equity market’s current price level to a benchmark, typically the long-term average value of the respective ratio. Figure 3, Panel A, shows each of the four metrics compared to its long-term average for the period 1871–2015. Panel B provides the same four-ratio comparison focused on the last 15 years. Values greater than zero indicate that the market is overvalued, or expensive, and values less than zero indicate that the market is undervalued, or cheap. The figures succinctly illustrate that these four metrics often tell the same story—and today that story is that the U.S. equity market is overvalued!
The charts in Figure 3 also highlight two distinct shortcomings of valuation ratios. The first is that they cannot be relied on for guidance in timing the market. Take, for example, the early 1990s. All of these measures would have indicated that the market was becoming overvalued. That may very well have been the case, but anyone jumping ship then