It is often said stocks must climb a wall of worry, and that seems to be the case with Wall Street breaking out to record highs while valuations appear high to many. But as this note shows, relative to bond yields, stocks don’t appear over valued and valuations seem far from levels that held prior to the four previous major market declines over the past forty years.
Bond-equity valuations not yet in the danger zone
Are US equities over valued? The most consistent long-run measure of US equity valuations is the price-to-trailing reported earnings for stocks in the S&P 500 Index. As at late-July, this PE ratio was around 23, which is above its long-run average since 1960 of 18 – and its average of 15 since the late 1800s.
So far so bad. But as evident in the chart below, the PE ratio tended to be lower in the past when interest rates were also generally higher. Indeed, since the early 1990s, the PE ratio has actually averaged 22.4 – even excluding the extreme values reached during the 2008 financial crisis due to sharp earnings downgrades. In fact, the market has spent around 6 of every 10 months since the early 1990s trading at a PE ratio above 20! The fact that interest rates have endured a pronounced cycle over the past 50 years (rising then falling) makes valuing equities based on long-run historical norms especially difficult.
Given the shift in interest rate trends over time, another valuation measure is to compare the market’s earnings yield (inverse of the PE ratio) with 10-year government bond yields. On this score, the equity-bond yield differential is currently around 2%*. As also evident in the chart below, however, the average level of this differential has also tended to change over time – it was higher in the 1960s and 1970s, then turned negative over the 1980s and 1990s, before consistently pushing back above zero again earlier last decade.
What can be said, however, is that by the standard of both recent and longer-run history, it is hard to argue the equity-bond differential is worryingly low.
More to the point, the equity-bond yield differential is well above the levels that prevailed just before the four major market downturns since the late 1960s. This is also evident in the table below: in the first three major market downturns (1973/74, 1987 and 2000-02), the equity-bond yield differential was negative. And just before the GFC it was around zero.
Could the S&P 500 PE ratio reach 30 or more?
Against this background, it begs the question just how far could equity prices go if inflation and bond yields remain relatively low? Even allowing for further modest interest rate increases from the US Federal Reserve, for example, it’s conceivable that US 10-year yields might only get to around 3% over the next year or so. If we then assume that equity market valuations only get vulnerable at a equity-bond yield differential approaching zero (as in 2007), then that would be consistent with the equity earnings yield also reaching 3% – or a PE ratio of 33!
Of course, it’s true that the market has rarely sustained a PE ratio of more than 30. But if it’s also true that bond yields are likely to hold at structurally lower levels, it’s also conceivable that the equity market’s PE ratio will also hold at structurally higher levels. In an era of structurally lower inflation, interest rates and economic growth, every dollar of earnings growth is likely to become more highly valued than it was in the past. And of course, to the extent the US market continues to rise, this also bodes well for local stocks.
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*The inverse of the market’s PE ratio of 23 gives 4.3%, less 10-year government bond yield of 2.3% generates a 2.0% equity-bond yield differential.
**Weighted in proportion to their underlying economic size as derived from earnings, dividends, cash flow and book value.