Are US Stocks Overvalued?
Warnings are coming from every corner that US stocks are pricey, including from myself in past posts. Is this really the case? In this post, I challenge my own and other bearish tones by considering the bigger picture. Here are a few charts used to support the “overvalued” case:
Cyclically-Adjusted Price-to-Earnings Ratio:
Total market capitalization to GNP:
Note that GNP is used, rather than GDP, but the actual difference is small between the 2 indicators. It would actually be better to use total market capitalization to WORLD GDP, since more and more of US corporate profits come from non-US economies, both for sales and for cost cutting via production efficiency and outsourcing.
There are MANY other indicators, such as “stock price to book value ratio”, etc. In any case, looking at these charts sure suggests stocks are pricey! BUT…
Comparing ratios with their past values is a useful guide, but this must be “corrected” for several things that change over time and cause a drift of the “normal level”:
- Growing future sales from expanding domestic and global demand.
- Changing corporate taxes and regulations.
- The average long run interest rate.
- Income inequality (higher = higher stock prices).
- Proportion of world buying US stocks.
- Changes in yield spreads due to changes of risk-return preferences.
Pricing stocks with changing business and market conditions
Like everything in financial markets, current prices reflect expectations about the future within current conditions and policies. The elements mentioned above must be taken into account.
Growing future sales from expanding domestic and global demand
The global economy is expected to expand considerably over the next decade, with mega markets offering new demand and supply chain opportunities: Asia, Africa, LATAM. These rising tides were NOT as clear for future demand until as recently as the turn of the century, so all past valuations likely did NOT include as much future global demand in pricing.
Taxes and regulations
The corporate tax rate in the USA changed since the WWII:
A permanently lower corporate tax rate alone justifies permanently higher stock prices, so that also suggests we should not put too much weight on price-to-earnings or price-to-GDP ratios before, say, the 1990s, and we should ALSO not forget the Trump general detaxation that occurred very recently and also supports stocks. Regulations have also been lifted by the Trump Administration, which ALSO supports stock prices.
Average long run interest rate
The average long run interest rate is very important for stock and asset pricing in general. A lower interest rate means higher asset prices. An implicit assumption in many analyses is that interest rates will “rise again” to “normal levels” (whatever that means for them), but as I explained in past posts, it is NOT likely that the average bond return or Fed policy rates will increase substantially for any extended period of time!
Here is the return on the 10 year government bond, which is a good proxy for “the interest rate”:
This alone suggests that stock prices should be permanently higher, hence the “price to-anything” metrics should be corrected for this phenomenon. For example, taking a hypothetical example of the simplified Gordon Pricing Model, the price of something giving 100$ perpetually (think a perpetual dividend or coupon, whatever) at a 6% interest rate would have a fair pricing around 1667$, yet at 2%, the fair value would be around 5000$, or 300% higher!
So. Again based on this metric, it is NORMAL that asset prices are “historically high”, and hence that “price ratios” are high relative to historical values, but NOT necessarily based on a deeper analysis of pricing.
Income inequality
If you give 100$ to a wealthy person, that 100$ is going straight to savings in the form of stocks, bonds, and real estate investments, because upper incomes are not living pay check to pay check. In economic parlance, we would say that wealthy people have a higher “marginal propensity to save.” There is growing incomes in the “top 10%”, especially after the drop in the top marginal income tax rate:
The goal of this post is NOT to have a debate over income and wealth inequality. I am just saying that income inequality has risen due to huge increases in top-10% incomes, and THIS also supports stock prices.
Proportion of world buying US stocks and changing preferences
These are “fuzzier” metrics, but think about the big picture now: the ONLY very large market that can absorb global capital that has growth and prosperity and a relatively interesting outlook is… the USA! China and India have that, but there is general distrust in their financial markets. So the ONLY large market with a good outlook that has “trustable” markets is the USA… so the USA is absorbing a lot of global capital, and probably proportionally more than before 1990, because there was growth and prosperity between 1950 and 1990 in Europe and Japan, while now these regions have structural issues due to demographics, politics, etc.
The lower interest rate context also causes changes in risk appetite. In other words, risk preferences may be partially endogenous to market returns, meaning that people are willing to take on more risk (buy more stock) than before, due to the lower zero-risk returns. This also changes average portfolio allocation and tilts demand to higher-risk markets, such as stocks.
Conclusion
Based on all this, it is NOT clear that US stocks are overpriced! ALL of the above-mentioned elements suggest permanently higher stock prices, so comparing ratios to history is NOT necessarily pertinent! I am not saying I “promise” stock returns, but I do say I am not as sure as I was that US stock markets are overvalued and asking for a correction — it could happen, yes, but there may still be gas in the tank for significant upside! Clap and share!
Pascal Bedard
