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BAM Intelligence

Is the Market Overvalued?

For a number of years now, well-respected financial experts, such as Jeremy Grantham of global investment management firm GMO and John Hussman of Hussman Funds, have been cautioning investors that the market, specifically the S&P 500, is vastly overvalued. Last year, I took an in-depth look at their forecasts, which predicted long periods of very low or even negative returns, and explained why a bear market wasn’t likely to occur for the reasons they cited: that valuations were too high and likely to revert to the mean.

The U.S. market has continued to defy predictions from Grantham and Hussman (among others), setting new highs. And with those new highs have come even more new warnings about the market being overvalued. Given all these warnings, and the questions about them I’ve been getting from concerned investors, I thought it was time to revisit the issue.

So today we’ll examine current market valuations to see if they seem “too high.” The following table shows current valuation metrics for the Vanguard 500 Index Fund (VFINX) and compares them to their 25-year average. The data for VFINX is from Morningstar as of June 30, 2016; the data for the 25-year average is from J.P. Morgan Asset Management.

Price-to-Earnings (P/E) 18.4 15.8
Shiller CAPE 10 27.0* 25.7
Dividend Yield (D/P) 2.4 2
Price-to-Book (P/B) 2.6 2.9
Price-to-Cash Flow (P/CF) 10.1 11.4**

*As of July 20, 2016 **20-year average due to data available

Based on the data, it seems hard to claim valuations are stretched to levels that would lead one to conclude that the market is overvalued, especially in light of interest rates being at historic lows. While the current P/E is a relative 16% above its 25-year average, and the Shiller CAPE 10 is a relative 5% above its 25-year average, the D/P is actually a relative 20% higher than its 25-year average, the P/B is a relative 10% below its 25-year average, and the P/CF is a relative 11% below its 20-year average.

This raises the questions: Are stocks really overvalued? And should we be expecting a major correction due to mean reversion? I just don’t see it in the data.

Estimating Future Returns

The best tool we have for estimating future returns is the Shiller CAPE 10 ratio. With the Shiller CAPE 10 currently at 27, the earnings yield is 3.7%. If we adjust for the Shiller CAPE 10’s 5-year average lag in earnings, and the fact that real earnings tend to grow about 2% per year, we get a real return forecast for the S&P 500 of 4.1% (3.7 x [1 + (5 × .02)]).

While 4.1% is well below the S&P 500’s historical real return of about 7%, with the current T-bill rate at just 0.25%, it still produces a significant equity risk premium (though lower than the historical level). Thus, at least in my view, it’s awfully hard to argue that the market is vastly overvalued and due for a correction.

In fact, it’s just as hard now as it was when Grantham first issued his warning of massive overvaluation (75%) in mid-November 2013, when the S&P 500 was at about 1,800. At the time, Grantham forecasted a real return to the S&P 500 over the next seven years of -1.3%. Although Grantham may yet turn out to be right, without even considering dividends, the S&P 500 has increased by more than 20%. Including dividends, the return would be greater than 25%. Examples such as these are why Warren Buffett advises investors to ignore all market forecasts, because they tell you more about the person making them than they do about the direction of the market.

One final note: I think it’s important to add that international valuations are much lower. For example, the current Shiller CAPE 10 for developed, non-U.S. markets is about 15, which produces a real return forecast of about 7.3%. For emerging markets, the Shiller CAPE 10 is about 12, producing a real return forecast of about 9.4%. Those return forecasts are roughly their historical averages, and they look even more attractive relative to the riskless alternative.

The Bottom Line

The bottom line? Arguments that the stock market is vastly overvalued and ripe for a crash due to mean reversion just don’t seem to hold water based on the data. No one can predict the future, and that includes the direction of the markets.

This commentary originally appeared July 27 on MutualFunds.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

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Chief Research Officer

Larry Swedroe is Chief Research Officer for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored 15 more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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