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The Stock Market Looks Cheap Based on this Valuation Measure

| July 17, 2017
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As the U.S. stock market reaches new highs, it is common for people to ask if the market has become overvalued. Based upon many absolute valuation metrics this appears to be the case, but looking at relative valuation tells a different story. 

Perhaps the most widely used measure of value is the price-earnings ratio. The inverse of this figure - the 'earnings yield' - is a better gauge because it allows for comparisons with rates of return of other asset categories. 

Currently, the earnings yield (using the cyclically adjusted price earnings ratio) is 3.33%. Over the past 30 years this yield has averaged 4.37%, so based on this measure the market appears to be “paying” very little and therefore may be expensive. While this absolute valuation method is popular it misses an important point: stocks (and their earnings yields) don't exist in isolation; they should be considered relative to other investment alternatives. To do this, I subtract the real return on the 10 year Treasury note from the CAPE earnings yield. This ‘relative earnings yield’ is currently 2.77%, which is above its 30 year average of 1.97%. The chart below shows that while the absolute earnings yield is below its recent historical average, the relative earnings yield is actually higher than recent norms.

Does this mean that stocks should rally to bring the relative earnings yield into line with its historic average? No, there are many factors that would argue against that view. The point of the exercise is not to make specific market predictions, but to help investors understand that so long as real interest rates remain low, the stock market isn't necessary overvalued. Note that real rates could rise by around 75 basis points before relative earnings yields would be back to average. This means that the 10 year Treasury note would need to yield around 3% before the relative valuation of the stock market and the 10 year Treasury would retrace to recent historical parity. 

Of course, a rise in rates isn’t the only potential catalyst that can change the current valuation dynamics. Second quarter earnings will be reported over the following weeks and if these reports come in strong, the earnings yield will begin to rise. More importantly, investors may be willing to pay more for stocks if they are exhibiting earnings growth even though a strong earnings season would make it very likely that the 10 year rate gets to 3% more quickly than currently projected. 

Specific predictions concerning the future path of interest rates, earnings reports, and investor appetites require a great deal of guesswork. What can be known, from past and present data, is that the stock market isn’t necessarily overvalued at this time. 

Have questions about the stock market and its valuation? Contact me at andrew@lpastrategic.com.

 

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