US stock market valuation is normalizing…slowly
Newton said that for every action in nature there is an equal and opposite reaction. The same can be said for the stock market, which continually discounts the future, albeit imperfectly and sometimes with significant, long-lasting doses of noise. Hold this thought as we update the numbers assuming higher (lower) prices/valuations align with lower (higher) expected returns.
The backdrop to our analysis is a summer rally that stumbled, apparently due to the latest attitude adjustment to the Federal Reserve’s policy outlook. As the Wall Street Journal explains: “Hopes of a Fed pivot have faded, sapping momentum in equities” as “further interest rate hikes threaten to put further pressure on stocks.” expensive parts of the stock market”.
In fact, the market trend (based on the S&P 500 Index) remained negatively skewed throughout. The recent rally looked encouraging for several weeks, but it was never clear that the main trend of the correction had turned from bearish to bullish.
The good news for long-term investors is that the further decline in the stock market implies that the expected return for a relatively long holding period has increased. How many? It is here that science retreats and the art of forecasting progresses.
How many ways can we estimate future returns? Do not ask. Instead, let’s keep it short and nicely charted and focus on Professor Robert Shiller’s cyclically-adjusted price-to-earnings ratio (CAPE), a widely watched (and sometimes criticized) valuation measure of the US stock market. In the long term, there is a relationship between CAPE values and the 10-year future annualized return, but it is subject to a lot of noise in the short term.
Presumably, the recent decline in the S&P has lifted the expected return. In theory, yes, but there is a problem: the market valuation has (and remains) high, based on filtering market returns through a CAPE lens. As such, it is not unreasonable to wonder whether the recent theoretical rise in ex ante yield has been subsumed by a valuation correction. Using the relationship between CAPE and 10-year future returns since 1971 implies that the current market valuation expects the future 10-year return of the S&P 500 to be less than 5% – and that’s nominal, before inflation. . That’s quite a haircut compared to the current gain of around 11% over the past decade (through July based on monthly data).
The recent decline in market prices has removed some of the scum from market valuation, but only slightly. Estimating the future based on this simple CAPE model suggests the potential for further decline in the long-term return of the future before a “normal” relationship between valuation and return (red regression line in the graph above) does not recover. The timing, of course, is open to debate. Ditto for deciding whether a CAPE model is a productive way to estimate expected return. Or, to put it in Newtonian terms: does (financial) gravity still apply?
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.