Vol. 1, No. 4 - October 21, 2021
By Ron A. Rhoades, JD, CFP®
Associate Professor of Finance, Gordon Ford College of Business
Director, Personal Financial Planning Program, Western Kentucky University
Financial Advisor and Content Specialist, ARGI Investment Services, LLC
To contact Ron, please email: email@example.com.
October 2021 Update on Asset Class Valuations
In this edition, I focus on questions sometimes raised by investors whom I have met with recently – is the U.S. stock market overvalued? If so, what should I do?
As with most other editions of Da Bear’s Perspectives, this is a longer read, with more detailed discussion of the issues presented. For those who dare to peruse the following, enjoy!
Despite some recent volatility, stock indexes for most of the world remain near their highs.
In particular, U.S. growth stocks are at high valuation levels, relative to their assumed mean level of valuations. U.S. value stocks are more reasonably valued, as are value stocks in Europe, Asia, and emerging markets.
Reversion to the mean of asset class valuations occurs quite often. Yet, absent an economic shock, reversion to the mean can take many, many year – possibly 10, 15, or even more than 20 years.
Due to reversion to the mean (or partial mean reversion), lower expected returns for several asset classes are anticipated over the next 10-15 years.
U.S. equity strategies employing multiple factors, such as the value, size, quality, and/or profitability factors may fare better over the next 10-15 years, compared to a “total stock market” approach.
The U.S. Stock Market (Overall) Is Substantially Overvalued
According to my own analysis of asset class valuations, as of the mid-October 2021, U.S. large cap growth stocks are particularly overvalued.
“Growth stocks” are high-priced stocks, relative to recent or projected earnings, revenues, book value, cash flow (or free cash flow), or dividends. “Value stocks” are “low-priced stocks” relative to the same measures. Different methodologies exist for classifying stocks as either “growth” or “value” (or something in between, often denoted as “core” stocks).
“Large cap stocks” are generally stocks of companies with a total stock market valuation (i.e., total value of all of the company’s outstanding stock) of $10 billion or greater.
The overvaluation of U.S. large cap growth stocks has, in turn, has influenced the entire U.S. large cap stock universe to be overvalued.
The overvaluation of U.S. stocks can be discerned from valuation ratios, of which there are many types.
This chart of the Shiller CAPE10 [also known as the P/E 10 ratio, or as the cyclically adjusted price-to-earnings (CAPE) ratio], is a valuation ratio that averages the past 10 years of earnings of the companies found within any country, or within any equity asset class. It most commonly is referred to as “CAPE10” as it is applied to the Standard & Poors’ 500 Index, which index includes 500 of the largest U.S. companies on a cap-weighted basis. By using an approach that levels earnings over 10 years (with inflation adjustments for prior years’ earnings), the Shiller CAPE10 avoids large swings in valuations that can occur when corporate earnings rapidly rise and fall.
The Shiller CAPE10 illustrates the present over-valuation of U.S. stocks, relative to the mean, with the ratio at 38.63 as of October 21, 2021 (slightly up from the 38.52 ratio seen on July 13, 2021).
Source: https://www.multpl.com/shiller-pe Retrieved Oct. 21, 2021
The historic mean of the Shiller CAPE10 valuation ratio (since 1870) is 16.88. However, due to changes in accounting practices and standards that occurred around 2001 (relating to how goodwill is written off), a reduction of dividend payouts, and other factors, some financial academics argue that a more reasonable “mean” might be around 19-26. Reflective of the general long-term trend toward higher equity values (using price relative to earnings), from January 2000 through October 2021, using monthly data, the arithmetic mean of the Shiller CAPE10 was 26.73, while the median was 26.15.
Additionally, many might argue that, given the extremely high monetary and fiscal stimulus seen since the start of the pandemic in early 2020, substantially higher valuations are justified.
The maximum value of the Shiller CAPE 10 valuation ratio was 44.19, which occurred in December 1999 at the height of the dot-com bubble.
The Shiller CAPE ratio is a good indicator for long-term forecasts, and may be one of the most statistically significant predictors of long-term U.S. stock market returns. A chart from Lyn Alden, looking at similar valuation ratios done for both U.S. and foreign markets, shows a strong negative correlation between high valuations of various stock indexes and future returns, when looking at the future returns over a 15-year period:
Past performance is not a guarantee of future results. The data shown in the chart referenced above is derived from multiple sources and is assumed to be accurate. Returns shown are “real returns” (inflation-adjusted), but such returns do not reflect the costs incurred by investing in specific mutual funds or ETFs, or directly into equities. The returns shown do not reflect ARGI’s (or any other investment adviser’s) investment advisory fees. Much of the data above is derived from country indexes; you cannot invest directly in an index.
However, there exists a wide dispersion of possible returns, even after the Shiller CAPE 10 ratio has reached very high heights.
Source: Research Affiliates
Reasons Why U.S. Stock Prices Are High
At times the market can appear “manic-depressive,” with stock market values being depressed relative to their assumed normal levels (“norms”). At other times the stock market can appear to be euphoric, with prices quite high relative to their norms.
In the present case, it appears that a major reason behind this extraordinary move of U.S. stocks is largely due to irrational exuberance. In this regard, stock valuations (both individually, and as broader asset classes) can be substantially driven by investor psychology. Investors tend to act with herd behavior, and as investors pour into equities other investors often follow them. In addition, other behavioral biases, such as “fear of missing out,” are often involved in changes to investor sentiment.
Another reason for high stock valuation levels is the potential role of low interest rates. In traditional financial theory, interest rates are a key component of valuation models. When interest rates fall, the discount rate used in these models decreases (assuming all other inputs into discount rates stay the same). This causes the price of the equity asset to appreciate, as future earnings of companies have greater value. This is particularly true with growth stocks, which often have higher earnings projected farther into the future. As the discount rate falls, the price of the equity asset should appreciate, assuming all other model inputs stay constant. So, lower interest rates are often used to justify higher equity prices.
Additionally, low yields on fixed income investors drive some investors to equities. Many investors conclude that there is no alternative to investing in equities if they desire to preserve the real value (i.e., inflation-adjusted value) of their wealth, or to outpace inflation over the long term.
Another argument in support of high prices is that the equity markets are simply pricing in a future economic recovery, as more and more Americans return to work following the recent COVID-19 pandemic. (Unfortunately, due to the Delta variant and other reasons, COVID-19 continues in the U.S. in a more limited way, and COVID-19 is still causing serious economic problems in many countries, especially those in which vaccination rates are low.)
Additionally, the monetary stimulus from the Federal Reserve (via low short-term interest rates, and quantitative easing, primarily) and the likely fiscal stimulus (arising from a multi-trillion spending package likely to be enacted later in 2021 through the reconciliation process, to which the U.S. Senate filibuster does not apply), may spur U.S. economic growth forward. Indeed, in late June 2021 the International Monetary Fund raised its 2021 U.S. growth projection sharply to 7.0%, due to a strong recovery from the COVID-19 pandemic and an assumption that much of President Joe Biden's infrastructure and social spending plans will be enacted.
The International Monetary Fund foresees strongeconomic growth, around the world, through 2022.
Still another reason, related to investor psychology, is the rise of the social media hype of certain “meme” stocks, such as Gamestop, AMC, Blackberry, Bed Bath & Beyond, Clover, SoFi, and others. Individual investors on Reddit and Twitter tout these and other stocks, often resulting in rapid growth of each company’s stock price. A disconnect occurs between the “intrinsic value” of a stock, and its stock price, as speculation is fueled. Panic selling of these stocks can often occur, even at the slightest adverse news or other headwind.
The Phenomenon of Reversion to the Mean
There is always a tendency to believe “this time is different.” Yet, reversion to the mean of asset class valuations, over the long term (15-20 years), is likely to occur.
The reversion to the mean principle suggests asset prices and historical returns eventually will revert to their long-run mean level. The academic evidence for mean reversion, over long periods of time, is fairly strong. For example, a recent academic paper reviewed a large sample of stock indexes in seventeen countries, covering a time span of more than a century, and analyzed in detail the dynamics of the mean-reversion process for the 1900-2008 period. They found that the speed at which stocks revert to their fundamental value is higher in periods of high economic uncertainty caused by major events such as the Great Depression, World War II and the Cold War. In essence, large price movements in relatively short periods of time - when great economic uncertainty exists - may account for a high mean reversion speed. However, at other times it can take many years, and even decades, for mean reversion to occur.
Similarly, Campbell and Shiller demonstrated that high valuation multiples such as aggregate book-to-market (BtM) or earnings-to-price (E/P) ratios, both of which signal low current prices, have been found to forecast high subsequent stock market returns.
However, mean reversion is not universally accepted in academic circles. Stock price movements occur for a variety of reasons, and it can be difficult to isolate mean reversion as the cause of movements in valuations of asset classes when so many variables exist. Some academics continue to favor the “random walk” theory of asset prices, arguing that mean reversions are not predictable.
Even if mean reversion is accepted (as it is in many financial circles), mean reversion does not always occur to the historical mean, as a new mean may be set by ongoing developments in the equity markets. As a result, predicting the effect on mean reversion of over-valuation or under-valuation might be tempered by assuming that mean reversion occurs only partially. As stated by Robert Arnott of Research Affiliates: “Valuation multiples, yields, and spreads have shown a powerful tendency to eventually mean-revert toward historical norms. However, since mean reversion is somewhat unpredictable, our models only assume partial mean reversion – spread out over the decade to come – in setting our return forecasts.”
Mean reversion – over the very long term – for broad asset classes, is highly likely to occur. However, I do not mean to suggest that high stock values today will cause declines in stocks in the near term (although it is possible). There is very little evidence to suggest that mean reversion for broad asset classes consistently occurs over short time periods, such as over 1 year, 3 years, or even 5 years.
As seen in the next section, high valuation ratio levels imply future long-term (15-20 year) lower return for certain stock asset classes.
Varied Opinions on the Expected Returns of Various Asset Classes.
There are many opinions about the future returns of stock asset classes.
Some estimates of 10-year expected average annualized returns for various asset classes are undertaken by several investment firms. The following summarizes their data, for select asset classes, for a U.S.-based investor. The Research Affiliates estimate also gives an indication of the wide dispersion that exists, as to possible future average annualized returns over the next 10 years.
U.S. large company stocks: 1.5% (RA) (with 5% probability of returns of 5.6% or greater,
and 5% probability of returns of -2.5% or less)
2.4% to 4.2% (VG)
U.S. small company stocks: 3.0% (RA) ) (with 5% probability of returns of 8.5% or greater,
and 5% probability of returns of -2.5% or less)
2.1% to 4.1% (VG)
Foreign developed markets: 6.4% (RA) (with 5% probability of returns of 11.0% or greater,
and 5% probability of returns of 1.9% or less) (EAFE)
5.7% (MSCI Europe) (SSGA)
4.5% (MSCI Pacific) (SSGA)
8.2% (Europe) (BR)
Foreign emerging markets: 8.3% (RA) (with 5% probability of returns of 13.9% or greater,
and 5% probability of returns of 2.8% or less)
Commodities: 1.4% (RA) (with 5% probability of returns of 5.7% or greater,
and 5% probability of returns of -2.9% or less)
[Projections above include data from Research Affiliates (RA) as of September 30, 2021 as derived from its Asset Allocation Interactive online resources, and from Vanguard (VG) as of June 30, 2021, and from State Street Global Advisors (SSGA) from its Long Term Asset Class forecasts as of September 30, 2021, and from the Blackrock (BR) Capital Market Assumptions - Asset Return Expectations and Uncertainty (as of June 30, 2021).]
[Please be aware that the information presented on the prior page represents local (U.S. dollar) return forecasts for several asset classes and not for any ARGI fund or strategy. These forecasts are forward-looking statements based upon the reasonable beliefs of the sources set forth below and are not a guarantee of future performance. Forward-looking statements speak only as of the date they are made, and neither ARGI nor Ron A. Rhoades nor any of the firms listed below assume any duty to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may (and likely will) differ materially from those anticipated in forward-looking statements. Asset return projections gross of fees relating to investments, or which might be charged by ARGI or another investment advisor.]
Note that while the foregoing projections assume reversion to the mean occurs over a 10-year period, I would again caution that mean reversion, in the opinion of some academics, has a greater probability of occurring over a 15-year to 20-year period.
Not all analysts project positive returns for stocks. For example, GMO LLC projects, over the next 7 years, -6.2% annual (nominal) returns for U.S. large company stocks, -8.2% annual returns for U.S. small company stocks, and -0.9% annual for international large company stocks. GMO does project that Emerging Markets Value stocks will possess an inflation-adjusted annual return of +2.4% over the next 7 years.) [Source: GMO 7-year asset class real return forecast, as of August 31, 2021.]
My own analysis (using price-book valuation ratios for the Russell indexes for U.S. stock asset classes over the past 40+ years, and Fama-French research indices for long-term returns), I further break down U.S. asset classes by value and growth stocks. Doing so shows a wider discrepancy in expected average annual returns over the next 15 years, as between growth stocks and value stocks, and illustrates that we are likely in a “growth stock” bubble:
U.S. large company growth stocks: -2.9%
U.S. large company stocks: 3.6%
U.S. large company value stocks: 5.6%
U.S. small company growth stocks: 1.7%
U.S. small company stocks: 8.7%
U.S. small cap value stocks: 9.5%
[Projections reflect market prices as of the close of trading on October 14, 2021 and utilize historical and current price-book ratio data for indexes and index ETFs from the Frank Russell Corporation, with adjustments to future returns undertaken by Ron A. Rhoades to reflect projected rates of inflation, and projections of U.S. economic growth, over the long term. Ninety percent of the reversion to the mean (as measured over the past 20 years) of asset class valuations is assumed, rather than full mean reversion. These projections are undertaken by Ron A. Rhoades, individually, and are not undertaken by ARGI’s investment department nor its investment committee. Forward-looking projections are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may (and likely will) differ materially from those anticipated in forward-looking projections set forth above, as there exists numerous factors at play and the dispersion of actual returns can be quite wide; only the median projection is shown. There exists academic research that reliance on price-book ratios may not be the best valuation metric to use as a forecaster of returns, given the rise of goodwill and other factors affecting book values, and changes in the industry composition of indexes, over time.]
Conclusion: Yes, A Growth Stock Bubble Exists
As of the date of this writing, U.S. stocks are likely in a “growth stock bubble,” similar to the prior bubble in growth stocks (i.e., high-priced stocks, relative to book value, or sales, or earnings) seen in 1999-2000. The driving factors behind these high valuation levels include speculation by individual investors and “euphoria” leading to chasing returns (as occurred 22 years ago).
However, in other respects the market environment is somewhat different than that seen in the “dot.com” era. Today’s “growth stocks” don’t just consist of many revenue-less technology stocks, but instead are led by large companies with more diverse revenue streams. Future earnings are of these larger, more established growth stocks are often projected quite high – and such future earnings are discounted less due to the relatively low interest rates existing today.
Please realize that none of these future asset class projections are “certain.” Forecasting investment returns, even over the long term, deals with probabilities, rather than certainty. As I instruct my students, as to the price factor:
“A highly diversified basket of value stocks (i.e., those stocks with low p/e, p/b, p/s, or p/cf ratios, or some combination of the foregoing) possesses an approximately 80% or greater probability of outperforming a diversified basket of growth stocks over any given 20-year period of time.”
I do not mean to imply that, in the event of a shock to either the financial system or to the economy as a whole, value stocks would have positive returns during such a period of time. Indeed, in the most significant market downturns in U.S. history (e.g., the start of the Great Depression, as well as the 2007-9 Great Recession), value stocks fell further than growth stocks. Simply put, some of the characteristics that classify stocks as “growth” also tend to promote the ability of those growth stock companies to better endure substantial economic declines.
Ever since early 2009, global equities have risen fairly steadily, with only moderate declines occurring (and the more substantial, but short, decline seen in Feb/March of 2020). But we must remember that the stock market does not always go up, even over 5-year and 10-year periods of time. In fact, there can exist substantial periods of time when the overall U.S. stock market underperforms the rate of inflation or just barely outperforms inflation.
What to do now?
A long-term investor will likely be well-served by substantial tilts away from growth stocks, and toward U.S. mid-cap/small cap value stocks, foreign developed markets mid-cap/small-cap value stocks, and emerging markets value stocks, over the next 10-15 years.
A multi-factor strategy, such as those incorporating factors such as the price (value) factor, size (small cap), quality, and profitability, possesses a high probability of outperformance, relative to U.S. equities overall, over the next 10-15 years.
Nearly three years ago I read where a well-known, large investment firm described the market environment as the most difficult one they had ever seen. Yet, since then, the equity markets – like poor Icarus of Greek mythology – have ventured even closer to the sun.
This does not mean that investing in stocks should be abandoned, especially since no other major asset classes appear to be undervalued at present. However, an advisor’s discussion of long-term changes to a client’s strategic asset allocation, and an advisor’s effort to re-set client expectations of future equity returns, may prove to be worthwhile.
Until the next time …
Very truly yours,
Ron (Da Bear)
 Using data I have accumulated on price-book ratios, it appears that, relative to mean and median levels, overvaluations exist for U.S. large company growth, balanced, and value strategies, and for U.S. small company growth, using Russell indexes for p/b ratios, and Fama/French data for historic returns. See later discussion in this article, for mean projections of returns.
 See, e.g., Rob Arnott, Vitali Kalesnik, and Jim Masturzo, “CAPE Fear: Why CAPE Naysayers Are Wrong,” Research Affliliates, January 2018.
 See, e.g., Lechner, Gerhard and Lechner, Gerhard. Does the Shiller CAPE Predict a Crash of the S&P 500? (March 17, 2021), in which the author concludes: “The forecast of the author is that the overvaluation will accelerate and exceed the previous peak of December 1999, because the monetary expansion will continue in 2021. The author believes it is likely that the new peak will be reached as early as 2022. After that, the risk of a stock crash increases sharply. Maybe, an increase in inflation and rising interest rates will cause a sudden drop.”
 Supra n.1.
 Keimling, N. (2015). Predicting Stock Market Returns Using the Shiller CAPE — An Improvement Towards Traditional Value Indicators? SSRN Working Paper, 1-39.
 Jivraj, Farouk and Shiller, Robert J., The Many Colours of CAPE (October 13, 2017). Yale ICF Working Paper No. 2018-22
 Shiller, R. J. (2015). Irrational exuberance. Princeton: University Press
 David Lawder, “IMF raises U.S. 2021 growth forecast to 7%, assumes Biden spending plans pass,” Reuters (July 1, 2021).
 Spierdijk, Laura and Bikker, Jacob Antoon and van den Hoek, Pieter. Mean Reversion in International Stock Markets: An Empirical Analysis of the 20th Century (April 1, 2010). De Nederlandsche Bank Working Paper No. 247
 Campbell, John Y., and Robert J. Shiller. 1988. “Stock Prices, Earnings, and Expected Dividends.” Journal of Finance, vol. 43, no. 3 (July):661–676
 See, e.g., Ronald Balvewrs, Yangru Wu, and Erik Gilliland. Mean Reversion across National Stock Markets and Parametric Contrarian Investment Strategies, The Journal of Finance, Vol. LV, No. 2 (April 2000), stating: “For U.S. stock prices, evidence of mean reversion over long horizons is mixed, possibly due to lack of a reliable long time series.”
 See, e.g., Yang, Xinye and Yang, Xinye, Economic Theory Foundations for the Long-Term Investment (March 18, 2021), stating: “Applying the Random Walk Theory to finance and stocks suggest that stock prices change normally, making it impossible to predict stock prices. The random walk theory corresponds to the belief that markets are efficient and that it is not possible to beat or predict the market because stock prices reflect all available information and the occurrence of new information is seemingly random, as well, in the short run. However, according to Burton Malkiel, the stock market does not conform perfectly to the mathematician's idea of the complete independence of the stock prices concerning past performances (Malkiel, 2003).”
 Rob Arnott, Jim Masturzo, “All Asset All Access: Long-Term Forecasts Help Identify Compelling Investments Today,” PIMCO Insights (Feb. 25, 2021)
 See, e.g., Choi, Ki-Soon and So, Eric C. and Wang, Charles C. Y., Going by the Book: Valuation Ratios and Stock Returns (August 26, 2021).
 Comparing an index for the overall U.S. equity markets (as measured by the CRSP 1-10 Index, with data provided by the Center for Research in Security Prices) to an index for consumer inflation (CPI-U, published by U.S. Commerce Department):
· The average annualized return for the U.S. equity markets was 10.09% for 1926-2000.
· The average annualized rate of inflation was 2.86% for 1926-2000.
· The worst nominal performance for the CRSP 1-10 Index was a -0.28% average annualized return over a 15-year period, which commenced in September 1929.
· The worst nominal performance for CRSP 1-10 Index was a 1.96% average annualized return over a 20-year period, which also commenced in September 1929.
· However, after adjusting for inflation, the worst real average annualized return for the CRSP 1-10 Index, over a 20-year period, was a cumulative 18% - still positive, but just barely.