Market Insights: Current U.S. Equity Valuations

Current U.S. Equity Valuations

We often hear through media outlets and some other sources that stock market valuations are historically high. There are various methods of valuation out there, but the one that seems to be cited the most for overvaluation is Robert Shiller's cyclically adjusted price-to-earnings (CAPE) ratio. However, it is our view that this ratio can be misleading due to the fact it uses trailing ten-year earnings which may not be overly useful for managing risk in a real-world investment portfolio. In addition, low interest rates and highly accommodative central bank activity may justify a higher ratio than other periods (this ratio does not take into account either). In the most recent Federal Reserve Financial Stability Report (FSR) from May 6th, the Fed noted that "some pressures have eased a bit since the November 2018 FSR". This November report was released December 18th. In other words, the Fed agrees that while market valuations are above historical average, conditions were more excessive six months ago. So, what we have seen then is valuation contraction, because stock prices are higher now than they were six months ago. Another way to look at that is earnings have performed better than price. 

We prefer to keep this simple and use the trailing one-year price-to-earnings (P/E) ratio. With valuations in mind, let's see how the stock market today compares to level that has been typical in the past. The chart below shows the P/E ratio for the S&P 500 for the last 25 years. As of a week ago, the S&P 500 traded for 17.4 times trailing earnings. This compares to 16.5 times on average over the last 25 years. From a long-term broader market perspective, this is about 5% overvalued in comparison to historical average. However, we certainly wouldn't view 5% as being excessive or anything to be overly concerned about, and especially considering the level of interest rates and inflation, which remain benign. As of the time of this writing, however, the market has turned sour and down 4-5% since then.  With that in mind, the P/E ratio has actually moved back, almost down to the historical average of 16.5x. 

One component of our Milestone Recession Risk™ Composite is another equity valuation metric called the Rule of 20 P/E. This looks at trailing one-year earnings and adjusts for inflation, with markets being under or overvalued from a fair value of 20. This particular metric has been much more useful when managing risk for portfolios, which is why it is our preferred method of valuation. As of today, this P/E ratio is down to 19.2 which represents a slight undervaluation currently. From a historical perspective, this rule does not suggest defensive positioning when the fair valuation within this metric is rising and the actual inflation adjusted PE is below that level. 

With this data, it seems evident that stock market valuations are not excessive, and perhaps justified considering the current level of interest rates, inflation and central bank activity.