Is the US stock market fairly valued?
·June 12, 2022
The US stock market fell sharply when COVID emerged in March 2020, but rallied even more dramatically afterwards, ending 2021 up 47% from its level at the end of 2019. Although its current value remains well higher than its pre-pandemic levels, the stock market has given up about half of those gains since the start of 2022, as fears of a recession mount. This generated a animated debate whether the market is currently priced fairly and what that means for its future prospects. Stock price theory and a historical perspective on stock market benchmarks provide insight into its current value and the reasons for its volatility.
The key to whether the S&P 500 is correctly priced at its end-May 2022 level is whether we expect the level of earnings in 2021 to be sustainable.
- Stock prices reflect expectations of future events, which affects stock price volatility. A company’s stock price reflects the expected present value of its future risk-adjusted dividend payments. The role of expectations is key – the value of the global stock market, as reflected in indices like the Standard and Poor’s 500, will change immediately today with new information on the outlook for economic growth, interest rates, rules and regulations that affect business, political factors or a host of other reasons. For example, new information that raises the prospect of a recession will tend to drive down stock prices as soon as that information becomes public. This immediate impact of news, rather than actual changes in conditions, makes stock prices volatile. There are many examples of this, such as stock market reactions to electionspost-election political developments, the pandemicand war.
- Fair valuation assessments of aggregate stock indices generally use currently available information rather than people’s expectations about the future, because it is difficult to obtain reliable measures of expectations. A popular indicator is the market value of a company’s stock (the stock price multiplied by the number of shares) relative to its annual earnings to calculate that company’s price-to-earnings (P/E) ratio. The aggregate price-to-earnings ratio for the stock market as a whole calculates the sum of the market values of all publicly traded companies divided by the total annual earnings of these companies. Profits are likely to be higher in a strong economy and lower during a recession, all else being equal, so John Campbell and Robert Shiller developed the Cyclically-adjusted price-to-earnings ratio (CAPE) to capture that. CAPE divides the value of the S&P 500 index by the average annual earnings of companies in the index over the previous 10 years; this longer-term average is used to smooth out the effects of the economic cycle. P/E and CAPE ratios can be compared to historical averages to assess whether the stock market is fairly valued, versus overvalued or undervalued. For example, at 32.1, the CAPE ratio as of June 3, 2022 was below its peak value of 44.2 (reached in December 1999) but well above its trough of 13.3 in March 2009.
- The most recent decline in the CAPE ratio has occurred primarily through falling stock prices rather than rising earnings – and this is consistent with historical experiences of declining CAPE ratios. A decline in the CAPE ratio occurs either through a decline in stock price, an increase in earnings, or both. The recent 15% drop in CAPE from 38.3 at the end of 2021 to its May value of 32.5 represented an 11% drop in the S&P 500 index (from 4675 to 4132) and an increase of 4 % of average income over 10 years (from 122 to 127).
- High values of the CAPE ratio are usually followed by falling stock prices. There is generally an inverse relationship between the value of the CAPE ratio at one point in time and stock price returns over the next decade (see chart). Each of the 1,200 monthly data points represents the month-end value of the CAPE ratio and stock market returns over the next ten-year period. The downward sloping relationship suggests that high CAPE values reflect periods of overvaluation potentially driven by easy credit or the irrational exuberance of investors seeking recent high returns. That said, there is far less independent data in the chart than it appears, since the return observations come from heavily overlapping time periods. In a sense, we only have two past observations of a CAPE above 30, 1929 and 1999 – and at both of these times there were subsequent stock price declines. But it should be noted that the relationship between CAPE and future returns seems to change over time – note that the level of CAPE consistent with slightly positive future returns was higher in the most recent period (in orange) compared to the period 1912-1941. Variations in the CAPE – stock return relationship over time suggest that the level of CAPE consistent with fair valuation may also vary.
- There are reasons why a higher than normal CAPE might be appropriate in 2022. First, interest rates are lower than inflation, so the real interest rate (the nominal rate minus the inflation rate) is negative. This should increase the amount an investor should be willing to pay for $1 of current income since income (and the dividends it funds) should increase with inflation while the alternative of holding a bond rather than a share is less attractive due to still low nominal interest. rates. Second, high price-earnings ratios in the United States partly reflect a sector sorting between the United States and Europe where the United States has more high-growth technology companies and Europe more slower-growing consumer goods companies. Third, CAPE, by design, under-responds to recent earnings growth. Earnings have grown very rapidly over the last decade: after not growing at all per unit of the S&P 500 between 2006 and 2016, earnings have almost doubled in 5 years, adjusted for inflation. When trying to predict future performance using past performance, it makes sense to give more weight to more recent performance. CAPE doesn’t do that; to compare value against equally weighted average past earnings, it implicitly takes the 10-year average as the forecast of future earnings. Valuations in 2021 look less like an outlier if we compare them to prior year earnings, as in the simple P/E ratio.
The key question in whether the S&P 500 is correctly valued at its level at the end of May 2022 is whether we expect the level of earnings in 2021 (about 200 per unit of the index) to be sustainable. First quarter 2022 results were stronghelped by the energy sector, and analyst forecasts for the rest of 2022 and 2023 are too and have indeed strengthened since the end of the year. But there are alternative views; Chicago Mercantile Exchange Dividend Futures, whose gains are tied to dividends paid per unit of the S&P 500 in a future calendar year, have declined 10-15% for 2024 and beyond, roughly matching the decline in stock prices. These markets do not seem convinced by the optimism of analysts. Much is currently being written about how inflation and the fight against it will affect earnings. In my view, the lessons we can learn from the 1970s, when high inflation was accompanied by stagnating incomes, are limited. It matters whether inflation is driven by the rising costs faced by S&P 500 companies or whether it is driven by their ability to increase the amount by which they mark up their costs. It doesn’t matter what form any recession induced by the fight against inflation will take. Earnings releases are watched even more closely than they normally are for clues about these issues. While the high value of metrics such as CAPE raises fears of overvaluation, even after the market dip earlier this year, I would argue that the level of CAPE consistent with a fair market valuation may well have risen. The key question is whether 2021’s high earnings turn out to be a post-pandemic event or the new normal.