Despite their recent sell-off US equities are still close to their most over-valued levels ever – but recent history suggests this might not matter much.
One measure of such over valuation is the deviation of share prices adjusted for inflation from their time trend (both measured in logarithms). I’ve chosen this measure simply because since the index began in 1871 it has done a better job of predicting longer-term returns than either the dividend yield or cyclically-adjusted earnings yield.
My chart plots this deviation. The story it tells is a familiar one – that equities were cheap immediately after WWI, in the 1930s and 1940s, and in the late 1970s; but expensive in 1929, the early 1970s and late 1990s. On all those occasions, the market subsequently behaved as you would expect, rising after being cheap and falling after being expensive.
In recent years, however, US equities have ceased to behave as they should. For much of this century, an apparently expensive market has simply got even more expensive. Which is not true only of this measure. The dividend yield and cyclically-adjusted price-earnings ratio also predicted medium-term returns for much of the 20th century, but have not done so since. Five years ago, for example, the cyclically-adjusted price-earnings ratio, at 28.9, was 72 per cent above its long-term average – but the S&P 500 has since risen by over 60 per cent after inflation.
Whatever valuation measure you use, the fact is the same: equities used to mean-revert with expensive markets falling and cheap ones rising, but this has ceased to be the case. In fact, the S&P 500’s real-terms price gains in the past 30 years have been close to the best ever – although thanks to low dividends total returns have been less spectacular.
Which poses the question: why have expensive markets simply become even more expensive?
It’s certainly not because the economy has done unusually well. Quite the opposite. In the last 30 years real GDP has grown by only 2.5 per cent a year. That’s a full percentage point less than it grew between 1955 and 1985, when share prices barely rose at all in real terms.
A more plausible reason for the market’s rise is that it has been driven up by fantastic returns on a handful of huge stocks such as Apple (US:AAPL), Amazon (US:AMZN) and Microsoft (US:MSFT). Hendrik Bessembinder at the University of Arizona estimates that between 1990 and 2018 just 1 per cent of stocks accounted for 71 per cent of the net wealth created in the US market.
This, however, is not the whole story. The Frank Russell 2000, an index of smaller stocks, has also risen strongly in recent years – albeit not as much so as the S&P 500.
One possible reason for this is that bond yields have fallen, causing investors to discount future earnings by less with the result that valuations have increased.
This explanation, however, runs into a problem. Insofar as bond yields have risen because of slower growth, equities should not have benefited at all: lower future dividends should exactly offset the lower discount rate. Which poses a danger. Perhaps equities are pricing in the good news of lower yields (a lower discount rate) but not the bad (lower growth). They could be doing the opposite of what they did in the 1970s, when they discounted future earnings more heavily because bond yields had risen, ignoring the fact that the same inflation that raised bond yields would also raise future earnings. Recent big falls in the price of Netflix (US:NFX) and Peloton (US:PTON) after news of weaker-than-expected earnings growth lends credence to this possibility.
It is only to the extent that bond yields have fallen for other reasons that equities should have risen; the most promising candidate here is simply that investors’ time horizons have increased so that they are willing to pay more for long-duration assets, be they long-dated bonds or equities.
There is, however, something else. New York University’s Sydney Ludvigson and colleagues point out that the rise in the S&P since the late 1980s is due largely to an increase in the share of profits in GDP: company owners have benefited at the expense of workers. This is consistent with the great performance of a handful of huge companies. Harvard University’s Lawrence Katz and colleagues have shown that this rising profit share is disproportionately concentrated among these superstar companies.
US equities, then, have managed to rise in the face of high valuations in recent years because of a rising profit share, the stellar performance of a few companies and because of falling bond yields. Their setback so far this year has coincided with a reversal of that fall in yields. A more interesting, and troubling, question for equities is: how would they fare if or when the share of profits in GDP turns down?
