US stock market valuations continued to edge higher through May, pursuing their uninterrupted stretch since March last year. The CAPE price earnings ratio hit 37.3 on May 28th, a level second only to the 2000 tech bubble highs, leaving reminiscent investors nervous and worried about an imminent correction, if not a crash. However investors should stop obsessing with valuations and instead focus on the fundamental drivers of long-term returns: long-term economic growth and growth uncertainty. While current valuations are undoubtedly high relative to historical standards, they are not high relative to bonds. And historically, such periods of high risk premia (or excess equity return over 10-year government bond yields) have signaled higher equity returns. According to our models, this high risk premia reflects investors’ perception of high economic growth uncertainty, driving a high demand for insurance against bad economic states in the form of safe assets (bonds). Thus the big risk for equity investors is not so much that valuations are high, but rather the uncertain path to recovery in long-term real economic growth.
More precisely, let’s start by examining the trends in equity valuations and government bond yields in detail. Exhibit 1 shows the monthly evolution of the cyclically adjusted price earnings ratio (CAPE) for the US equity market since 1990 (a popular measure of equity valuations developed by Robert Shiller), and the inflation-adjusted yield on the US 10-year constant maturity treasury bond. The Exhibit makes two key points. First, it shows that investors are right to be concerned with valuations: current valuations are high when compared to historical levels. Indeed, the CAPE averaged 37.3 in May, significantly up from 24.8 in March 2020, when the pandemic spread to the US. The only other time the CAPE got higher than 35 was around the TMT bubble, in March 1998 and November 1998. It reached its highest value of 44.2 in December 1999, at the height of the TMT bubble. Second, the Exhibit also shows that real (inflation-adjusted) government bond yields are currently at their lowest value (in the last 30 years), in negative territory and averaging -90bps since March last year.
In other words, ultra-low real discount rates may well be the primary driver of the observed high valuations. High valuations coinciding with an ultra-low real interest rate environment have not been observed in the US (at least since 1925). From this perspective, this time may well be different!
Thus, while valuations are undoubtedly high relative their past historical average, they are not that high relative to government bonds, on an inflation-adjusted basis (bond yields and prices move in opposite directions). This point is best illustrated in Exhibit 2, which shows the evolution of the excess CAPE yield for the US equity market, the difference between earnings yield and the 10-year constant maturity, inflation-adjusted treasury bond yield, and a measure of risk premia.
Exhibit 2 also shows the evolution of investors’ perception of uncertainty about long-term trend economic growth, based on our models, as implied by both macroeconomic and markets fundamentals. Consistent with our models, risk premia are closely linked to macro uncertainty. This link carries two important takeaways for investors. First, in our models, there is a tight connection between macro uncertainty and bond yields, and macro uncertainty and equity risk premia. According to our models, acutely high levels of macro uncertainty induced by the pandemic have further raised investors’ demand for insurance in the form of safe assets (inflation-linked government bonds), pushing real bond yields into negative territory, and driving both equity valuations and the required return on equities relative to bonds (risk premia) to higher levels.
Second, the big risk for equity investors is not in the standalone observation that valuations are high. Rather, the risk lies in the uncertain road to recovery in long-term trend growth, especially in the light of recent announcements around massive, stimulating fiscal policies. According to our models, a receding uncertainty around low(er) trend growth is consistent with a relative decline in risk premia and lower long-term returns. However, lower uncertainty around a higher trend growth could well be consistent with higher long-term returns! The right question for investors, then, is what are the paths for long-term trend growth and real growth risk. We will explore the impact of alternative economic growth (and inflation) scenarios in a subsequent note.
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