Garth Friesen
Are US stocks rich or cheap? It all depends on which metric you choose. Here are five indicators with data going back to 1990:
Say what you want about bond yields, but you can't say equity valuations are rich compared to long-term interest rates. The relationship between the equity market and the bond market is captured through the "risk premium". It is calculated by subtracting the 10Y US Treasury yield from the S&P 500 earnings yield (1/PE Ratio).
While not as high as 2013, the equity market still offers a 3.16% premium over bonds.
Most people are familiar with the Price/Earnings ratio as a measure to value stocks. You can use trailing 12-month earnings or some forward-looking earnings estimate. There are merits to both. Given the recent passage of tax reform, which included a material reduction in the corporate tax rate, forward after-tax earnings are expected to grow significantly. Using the 1-year forward P/E ratio as a metric, the S&P 500 is just slightly rich to the average level since 1990.
The Shiller CAPE (Cyclically Adjusted Price Earnings) Ratio is the opposite to the forward P/E Ratio. Rather than looking at 1-year forward profit expectations, it looks at the trailing average of the last 10 years of GAAP earnings. The purpose of using a long-term average is to remove the cyclical effect on corporate earnings due to the business cycle.
Unlike the forward P/E metric, the Shiller CAPE ratio indicates stocks are comparatively rich to their history. The current ratio is 34 times 10-year average earnings, compared to a multiple of 25.6 since 1990. The really, really long-term average, calculated from 1871, is closer to a 16 multiple. Bottom line: the Shiller P/E indicates the equity market is rich to its recent history, and very expensive relative to the inception of the data collection.
Past performance is not a valuation metric, but it does give an idea of how much a market has run relative to another. The above charts compares the total return of the the S&P 500 to the MSCI All-Country (Ex-US) Index, which is a market-cap weighted index that includes both developed and emerging markets. The performance of the US market has come from two primary sources: an expansion in the price-to-earnings multiple compared to global stocks, and higher earnings growth relative to the rest of the world. Global stocks are close to their average long-term historical valuations whereas the US market is richer based on most criteria. A reversion to mean valuations would result in the under-performance of the US market vis-a-vis international stocks.
Another way to value the equity market is to look at the total market capitalization of all stocks compared to GDP. Warren Buffett has referred to this indicator in the past, saying "it is probably the
best single measure of where valuations stand at any given moment." Globalization, profit margins and the level of interest rates all probably have something to do with the current level. But at this moment, the measure indicates US stocks are at their richest level in the last 30 years.
