Stock Market May Not be as Overvalued as Some Believe

Larry Swedroe of Buckingham (independent member of BAM Alliance) says that stocks are not nearly as overvalued as many leading commentators and analysts suggest. He offers six reasons  that, he says, “lead me to conclude that the market, at the very least, is not dramatically overvalued” and “may not even be overvalued at all, just more highly valued.” These are:

  • Use of 135-year historical mean
  • Changes in accounting rules
  • Changes in propensity to pay dividends
  • Changes in the strength of corporate balance sheets
  • Improvements in liquidity

The CAPE 10, or Shiller cyclically adjusted price earnings ratio, uses a 10-year earnings average to predict future performance and inform understanding of whether stocks are properly valuing companies. Its widespread use is a major reason many commentators and analysts see the market as very overvalued. The CAPE 10 suggests the current valuation is at around 26 against a long-term (135-year) average of about 16.6. Swedroe argues that the CAPE 10 historical mean is far too low because it does not account “regime changes” that have made investing less risky and, therefore, legitimately increased the value (price) of stocks. Safer investments are worth more, not overvalued.

Major historical regime changes, according to Swedroe, include the creation of the Federal Reserve and the SEC. More recently, he points to changes in accounting rules in 2001. With these regime changes factored in, Swedroe says “the correct mean to look at would be [approximately] 24, and we’re at 26 . . . maybe we’re slightly overvalued.”

On top of the effect of regime changes, Swedroe points to improvements in liquidity, especially reduced transaction costs for investors, and financial innovation, such as creation of small-cap index funds, as additional reasons that P/E ratios should be higher than the currently popular CAPE 10 historical mean would suggest.

The take-away for investors? While a bear market is not impossible, it “would not occur because stocks were correcting this pricing of overvaluations, as they did in March 2000, but because we had some black swan event . . . that would cause the equity risk premium to rise.” Further, “high valuations,” while not a way to time the market, according to Swedroe, “mean expected returns are lower.” He points to estimates of real returns in the 4-4.5% range (6-6.5% with 2% inflation), which is “a lot lower than the 10% return that we’ve earned historically.” Add longer life expectancy, and Swedroe says “[t]oday’s investors are facing a perfect storm” and “they’re going to have to take that into account as they build their plans.”