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Common Measures Of Aggregate Stock Market Valuation Should Be Taken With A Grain Of Salt

Feb. 18, 2021 10:46 PM ET
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Long Only, Value, Growth At A Reasonable Price, selective contrarian

Seeking Alpha Analyst Since 2018

I write about value/GARP stocks, and have been investing in stocks since around 2015 -- prior to that, I held index and mutual funds. I'm a lapsed economist based in Canada with 10+ years work experience, hold an MA in economics, and an undergraduate degree spanning economics, geography, and comp sci. My interest in stock investing came about by seeing it as a personal/intellectual challenge (and an opportunity for improved financial returns ;) -- it also defies dogmatic theories about the world. Some books that I've found worthwhile include Beating the Street (Peter Lynch), Superforecasting (Tetlock and Gardner), Buffett (Roger Lowenstein), and Common Stocks and Uncommon Profits (Philip A. Fisher), among others. Usually I lean towards value-oriented stocks, although I aim to be open-minded and opportunistic.


  • A range of measures try to put the aggregate stock market's valuation into perspective.
  • These include the CAPE ratio, the Fed Model, and market capitalization to GDP, among others.
  • Even when there is no aim to "time" the market, such measures could ostensibly help to gauge the temperature of the market, and to set long-run return expectations.
  • I focus on the CAPE ratio, and point out some shortcomings that are pertinent especially as North American markets have been reaching new highs, lately.

Investors have looked to a range of measures over the years to try to understand where the stock market's valuation is situated in terms of its cycle, and to read the tea leaves on future returns.

Among the simplest ways to gauge the market's valuation are the earnings yield and P/E ratio. But these fail to account for the inevitable cyclicality that an economy experiences. Recessions lead to lower earnings that will understate earnings potential over the long term -- the reverse is true for boom periods. So the P/E ratio and earnings yield look too pessimistic in recessions, and too optimistic during more euphoric episodes.

The Fed Model gets *slightly* more nuanced, and deems the stock market to be overvalued if its earnings yield falls below the yield on 30-year government bonds, and vice versa when the opposite is the case, since investors might tend to shift to whichever yield is higher. Although this model fit the data well for a couple of decades prior to the dot-com bubble, it hasn't done as well outside of that time period. A shortcoming of the Fed Model is that bond returns are exposed to inflation, while corporate earnings are subject to considerable uncertainty.

Market capitalization to GDP is a measure that Warren Buffett has favoured. As you can guess, it divides the total stock market capitalization of a country and divides by its GDP.  This has the advantage that the denominator normalizes the series, while generally being less volatile than the numerator, to give a through-the-cycle perspective on valuation. It could be influenced, though, by changes in the size of the publicly-traded corporate sector relative to the overall economy, over time.

The CAPE Ratio

The Cyclically-Adjusted Price-Earnings (CAPE) ratio takes price and divides it by a trailing 10-year moving average of real earnings --- this should help to at least partially adjust for cyclicality.  The CAPE first appeared in a 1996 paper by Robert Shiller (later versions were co-authored with John Campbell) in the lead-up to the dot-com bubble that ultimately peaked in March 2000. They found that the CAPE ratio helps predict stock market returns over a 10-year horizon (they get an R-squared of 40% in their 2001 paper).

As of February 2, 2020, the CAPE ratio was 34.8, just over twice the historical average of ~17.2, but still some ways from the all-time peak of 44.2 in December, 1999.  For Robert Shiller's total return version of the CAPE, these numbers are 38.1, 20.6, and 48.1, respectively.  I won't dispute that elevated valuation measures, as seen with the CAPE ratio, are indeed a cause for caution given their possible implications for returns over the next several years.

Possible Shortcomings of the CAPE Ratio

There are drawbacks to relying much on the CAPE ratio for investing guidance, though.  Notably, it has been well above its historical average for most of the last 30 years, so it could have easily led one to under-invest in the stock market during a time period where the S&P500 had a total return of roughly 2000%.

Data by YCharts

North American total stock returns have compared favourably with total bond returns, as well, as seen in the next chart -- the bond series that I found only goes back to about 2004. Even if the stock market drops by 50%, it would be comfortably ahead of bond returns over this period.

Data by YCharts

In "Stocks for the Long Run", Jeremy Siegel points out a few issues that could lead to higher long-term valuations. These apply to the CAPE ratio, but also to other valuation ratios, more generally:

  • A fall in transaction costs
  • Lower real returns on fixed-income assets
  • A decline in the equity risk premium

Siegel cites work by Charles Jones of Columbia University to infer that over much of the 20th century, it could have cost an investor 1 to 2 percent per year to acquire and maintain a diversified portfolio of common stocks.  By comparison, today a broad-market ETF costs a fraction of a percent, annually.

After decades of evidence that stocks have outperformed bonds over the long-run, you would also expect investors to eventually catch on to this.  That should lead them to bid-up the prices for stocks, to some extent, thereby reducing the equity risk premium. 

The equity risk premium could encompass other contributing factors. For instance, at some point later on in the 20th century, institutional investors shifted more of their allocation into equities. In general, there is more liquidity sloshing around globally, than in previous decades. Information is also more freely available, now, which should reduce opacity and asymmetries of information, making investors more willing to take on risk exposure to specific stocks.

The books "Irrational Exuberance" by Robert Shiller, and "Stocks for the Long Run" by Jeremy Siegel, are good complements for one another.  Personally, I found the latter book to be a better practical guide to stock market investing, but this could depend on one's own personal inclinations. If one tends towards an abundance of caution, particularly in the face of short-term market turbulence, "Stocks for the Long Run" can be helpful for retaining some optimism. Others that tend to throw caution to the wind might find "Irrational Exuberance" to be more helpful and sobering.

Final Words

The perpetually-high CAPE ratio was actually one of the reasons that dissuaded me from more fully embracing the stock market over the 2005-2015 period. Even during the financial crisis of 2008-2009, the CAPE ratio barely dipped below the historical average!

On further reflection, I'm persuaded by the arguments for why the long-term "equilibrium" of certain valuation measures should be somewhat higher than they were in the 20th century.  Analysis of economic data is susceptible to the problem that relationships between variables can change over time, particularly over many decades. Furthermore, aggregate valuation measures can only do so much for guiding decision-making on a day-to-day and year-to-year basis.  

Still, the apparently steep valuations of North American stock markets in recent years has helped to push me towards investing in individual stocks, in the belief that this might improve my chances of getting reasonable returns (I've had other reasons to get interested in stock investing, but that's another matter). Some sectors are frothier than others, and my previous blog post addresses the notion that there could still be opportunities in individual stocks.

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