Talks of a stock market bubble in the US continue to percolate through the financial media as the S&P500 (NYSEARCA:SPY) sets all time highs, feeding on the bubble fears. Investors cite multiple valuation measures such as P/E ratio, cyclically adjusted P/E ratio, EV/EBITDA, high levels of margin debt suggesting S&P500 is at overvalued levels. Recently market value as a ratio of Gross National Product has gained enormous popularity, cited as the best single measure of where valuations stand at any given point. I had been intending to evaluate the possible relationship, which exists between the Fed's measure of market value of equities, corporate profits and equity risk premium. This article looks at two theories: a) Can an aggregate P/E ratio drawn from the Fed's market value of equities and corporate profits predict stock market returns. b) Is it premature to be calling this market a bubble?
Aggregate P/E Ratio (Fed's Market Value of Equities / Corporate Profits)
Most of the arguments about whether stock market is in a bubble are built around the standard metrics, where earnings multiples are compared across time and markets. I substituted the P (price) part of the multiple with the Fed's measure of market value of equities and earnings with corporate profits. As the chart below explains, aggregate P/E closely tracks the inflation-adjusted price of the S&P500. This ratio digressed from the S&P500 composite from 1958 until 1965. To overcome the variation due to business cycles, investors use Cyclically Adjusted Price Earnings ratio (Shiller's P/E10). Second chart highlights the relationship between the aggregate multiple and the Shiller's P/E.
Source : Federal Reserve Economic Data
Source : Robert Shiller Website
Yield Gap and Equity Risk Premium
Yield gap - difference between the earnings yield and the ten year treasury bond yield - continues to contradict the bubblicious chatter presented by the financial community using lofty valuation levels to support their argument. Chart below highlights the yield gap using Shiller's P/E and aggregate P/E. At present yield gap (using both metrics) continues to be positive, forecasting positive excess returns for the market, both at the short and long horizons.
(Source : FRED & Robert Shiller website)
Predictability associated with yield gap at long-term horizons is strong because of the absence of predictive power in dividend growth, payout ratio, and earnings growth. Over the past several years, stock prices have risen more on steady earnings than on valuation, cash flows have gone into bonds instead. Investors continue to demand more compensation for holding equities, current equity risk premium of 4.96 percent is 100 basis points higher than long-term average of 3.96 percent. Robust profits, high margins, and healthy balance sheets of US corporations have supported these gains in the equity markets and an acceleration in investment spending by the businesses can provide extra boost to the economy.
What's different this time?
Investors continue to use the mean reversion themes in valuation metrics to support their bearish thesis but are inconsistent in applying their theories. If mean reversion theory has to hold true, it should be applicable to equity risk premium which currently is at lofty levels as well. Evidence from the yield gaps suggests that this period bears little closeness to previous bubble peaks. A slow but steady and sustainable economic cycle will continue to provide a better environment for US equities.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.