Each metric has its merits. Dividends and growth tell us what to expect companies to produce for their shareholders, and relative prices tell us what to expect from mean reversion in the price of that production. Together, they present a more complete picture of equity valuation levels, although certainly not the only one. That is why we estimate long-term equity valuation by combining both types of metrics: relative value and absolute value. We value global equity markets as the sum of dividend yield and growth in earnings, capturing market return in a constant-yield environment, as well as considering the reversion of CAPE to its long-term average.3
The choice of CAPE is not without its critics, who are quick to point out that changes in accounting rules and changes to the CPI calculation, along with the timing and benchmark issues inherent in relative valuation measures make CAPE an unreliable metric. All of these are valid criticisms, but as we’ve shown, all the relative valuation metrics tell the same story. And for those who shy away from choosing a metric because they all have blemishes, don’t forget that “in the valley of the blind, the one-eyed man is king,”6 even if everyone around him is skeptical.
Our answer to the question “Are stocks overvalued?” in the U.S. market is a resounding “Yes!” Our forecast for core U.S. equities is a 0.8% annualized real return over the next decade. The 10-year expected real return for emerging markets equity, however, is much higher at 5.9% a year. The return potential of the nondeveloped markets is so high, in fact, that the valuation models, warts and all, paint a very clear picture.
For readers interested in more details, please visit our Asset Allocation site.
1. In a box plot, the box represents the range of the middle quartiles (25th to 75th percentile) of returns. The whiskers extending from the top and bottom of each box show the maximum and minimum returns, respectively.
2. The Gordon growth model is represented as r = D/P + g, where D/P is dividend yield and g is capital gain (i.e., appreciation yield).
3. For readers interested in more details, our equity methodology document is available in the Asset Allocation section of our website.
4. A better estimate of earnings yield would incorporate average earnings over time, as does the CAPE (Shiller P/E) ratio; a discussion of CAPE appears later in this article.
5. Relative metrics are anchored to their long-term historical levels and assume a 50% return to those levels over the next 10 years via a change in price only.
6. The character Nunez appears in H.G. Wells’ The Country of the Blind, and Other Stories. Nunez was an explorer who discovered a village where everyone was blind, but over the generations had been able to hone their other senses. In addition, they developed stories about how the world “looks.” When Nunez arrived and described the world as he—a man with vision—saw it, the villagers scorned him as a liar.
Arnott, Rob. 2011. “King of the Mountain.” Fundamentals, Research Affiliates (September).
Greenspan, Alan. 2008. The Age of Turbulence: Adventures in a New World. New York: Penguin Press (p. 177).
Pleven, Liam. 2015. “Stock Prices: Is ‘Quite High’ Too High?” Wall Street Journal (May 15).
The Fed. 2015. “Yellen Says Stock Valuations Are ‘Quite High,’” MarketWatch (May 6)
Tobin, James. 1969. “A General Equilibrium Approach to Monetary Theory,” Journal of Money, Credit, and Banking, vol. 1, no. 1 (February):15−29.