Are stocks dangerously overvalued? Not according to new Vanguard yardstick

July 27, 2018

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Despite recent volatility, stocks seem overvalued by traditional measures. And while Vanguard always advocates the long-term view, for some—participants nearing retirement, institutions trying to meet short-term obligations, and others—the possibility of a substantial correction is of major concern.

But are stocks dangerously overvalued? It all depends on the yardstick.

Inside or outside the bubble?

At the end of 2017, the Shiller CAPE (cyclically adjusted price to earnings) ratio was flirting with all-time highs, surpassed only by the peaks that preceded the collapse of the dotcom bubble. It stood at about 33; its historical average is about 16. A reversion to the ratio's long-term average would bode ill for future stock returns.

Vanguard's "fair-value" CAPE ratio paints a less alarming picture, suggesting that valuations are indeed high but not in the "bubble" territory implied by the conventional CAPE. We expect the returns of U.S. stocks to fall below their historical averages over the next ten years. The most likely outcome, according to our projections, is annualized returns of 3%–5% for the coming decade.

For plan sponsors and retirement savers, that outlook is subdued, but not nearly as bleak as those suggested by tools that fail to account for today's low interest rates and inflation.

The evolution of forecasting tools

Short-term stock market forecasting can be a perilous undertaking. However, some valuation indicators, and the traditional price/earnings (P/E) ratio in particular, have shown a modest historical ability to forecast long-run returns.

In the late 1990s, professors Robert Shiller and John Campbell proposed an adjustment to improve the traditional P/E ratio's predictive power. Instead of dividing a market's current stock price by the average earnings per share generated over the prior four quarters, they divided it by the average inflation-adjusted earnings per share generated over the prior ten years. That modification captures the earnings power of the market over a business cycle better than a single year of earnings does.

As the figure below illustrates, the Shiller CAPE ratio provided a fairly accurate forecast of 10-year-ahead returns—for a while. Since the mid-1990s, however, this metric's predictive power has deteriorated. Contrary to expectations, the ratio has failed to revert to its long-term average for long periods. As a result, the metric has projected lower returns than those actually produced by the stock market. The notable absence of a reversion toward the Shiller CAPE's long-run average has raised doubts about its continuing usefulness in forecasting stock returns in real time.

Another step forward: Vanguard's fair-value approach

Vanguard Investment Strategy Group's fair-value CAPE approach started with an observation: A long-term decline in interest rates and inflation depresses the discount rates used in asset-pricing models. The upshot is that investors are willing to pay a higher price for future earnings, thus inflating P/E ratios. The critical implication is that there is no reason for the CAPE ratio to revert to its long-term average. Instead, it should be expected to revert to a level that reflects current economic conditions.

To test our hypothesis, which breaks with the standard assumption that the CAPE will mechanically revert to its fixed long-run average, we used real interest rates, expected inflation, and measures of financial volatility as proxies for the state of the economy to arrive at a "fair value" for the CAPE ratio.

More about our methodology and calculations can be found in our paper, Improving U.S. Stock Return Forecasts: A "Fair-Value" CAPE Approach, published in the Winter 2018 issue of The Journal of Portfolio Management.

The results in the chart below strongly suggest that adjusting the "long-term average" P/E ratio to account for macroeconomic conditions results in more accurate real-time projections of actual 10-year-ahead returns.

The fair-value CAPE has proved better at forecasting

1970 through 2016

Notes: For the real-time analysis, the regression coefficients are determined recursively, starting with 10-year trailing annualized returns from January 1901–December 1959 data and re-estimating the regression coefficients with the addition of data for each month thereafter.
Source: Davis, Joseph, Roger Aliaga-Diaz, Harshdeep Ahluwalia, and Ravi Tolani, 2018. Improving U.S. Stock Return Forecasts: A "Fair-Value" CAPE Approach.The Journal of Portfolio Management, 44 (3): 43-55. © 2018 Institutional Investors LLC. All rights reserved. https://www.iijournalseprint.com/JPM/Vanguard/Wint18ImprovingUSStock9at/index.html

It's worth noting that our fair-value CAPE would appear to explain both elevated CAPE ratios and robust stock returns over the past two decades. This more accurate measure can be a useful tool for plan sponsors. With a better sense of prospective stock market returns, sponsors can help their plans and participants find the right balance of saving, spending, and investing decisions to help them reach their goals.

For more information on our market outlook, please see our Global macro matters paper.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • IMPORTANT: The projections or other information generated by Vanguard’s fair-value CAPE approach regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.