U.S. Equities: Valuations Per P/B Ratios

I've grown increasingly concerned about stock market valuation levels.

There are many ways to determine valuations of individual stocks, and then by extrapolation the valuation levels of asset classes or the overall U.S. stock market. Some measures, however, such as P/E ratios, are highly volatile and can at times yield valuation measures which are even, at times, nonsensical. CAPE is, in my view, a better way of determining price on the basis of earnings, given that earnings are smoothed over a decade, although as many have written various adjustments may (or may not) need to be undertaken for CAPE.

Other measures of valuation tend to incorporate yields on U.S. Treasury bills, notes or bonds. While there is much intellectual underpinning to this approach, if you are a short-term investor, I am suspect of the introduction of bond yields into equity valuation models for purposes of a very long-term (15 year or more) investor. Over any 15-year period yields can tremendously vary.

For over a decade I've primarily relied upon price-book ratios to provide me a sense of how overvalued, or undervalued, the U.S. stock market may be. Why? First, for the Russell 1000 and 2000 indexes (growth, balanced and value) I've been able to reconstruct an estimate of the average p/b ratio, going back to 1977. This gives us 34 years of data to come up with an average. Second, p/b ratios for Russell indexes are provided monthly, giving us fairly up-to-date measures. Third, book values don't fluctuate wildly over the short term.

Of course, there are downsides to the utilization of price-book ratios. Since 1977 the U.S. economy has moved substantially away from capitalization-intensive industries and toward service industries. As part of this evolution, new industries have substantially grown, such as computer software, which are not very capital intensive. And many companies have outsourced their manufacturing to companies in China, the Phillippines, Indonesia, or other countries, thereby lowering the book equity. Hence, one can argue that the "mean" for price-book ratios should be higher than the "1977-2013 Estimated Average P/B Ratio" shown below.

Current (12/7/2014) valuations of U.S. stock asset classes are as follows, based

upon price-book measures of these asset class relative to 1977-2013 norms,

with further adjustments reflecting 11/1/2014-12/5/14 returns:

ASSET CLASS	10.31.14 P/B Ratio	P/B Ratio after 11/1-12/5/14 returns adjustment	1977-2013 Est. Avg. P/B Ratio	Percent Overvaluation / (Undervaluation) Relative to Estimated Average P/B Ratios	Resulting Adjustment to Asset Class Historical Rate of Return
U.S. Large Cap Growth	5.26	5.42	4.0	35%	-2.1%
U.S. Large Cap Balanced	2.75	2.83	2.3	23%	-1.4%
U.S. Large Cap Value	1.84	1.89	1.6	24%	-1.4%
U.S. Small Cap Growth	4.11	4.15	3.2	30%	-1.8%
U.S. Small Cap Balanced	2.24	2.26	1.8	26%	-1.5%
U.S. Small Cap Value	1.54	1.56	1.3	20%	-1.2%

Source: Data based upon Russell Indexes for U.S. stock asset classes, and Vanguard funds monthly/MTD data, as accumulated and analyzed by ScholarFi Inc. All measures of overvaluation/undervaluation are estimates, only. An adjustment is then made to available month-end data, derived from Russell Index data site, for changes in prices over subsequent period to date shown. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RETURNS. For educational purposes only. No warranties are provided as to the accuracy of the data provided.

The last column in the chart above reflects an adjustment to estimated average rates of return for the asset class, should reversion to the mean occur over a 15-year period.

Just because the stock market is "overvalued" does not mean that valuations cannot go much higher. In fact, following are the "low" and "high" markets of the valuations for the foregoing asset classes during the 1977-2013 era (with 12/6/2014 "current" estimated valuations shown again, for comparison purposes):

ASSET CLASS	Lowest P/B Ratio (Month/Year)	Current Estimated P/B Ratio (12/5/2014)	Highest P/B. Ratio (Month/Year
U.S. Large Cap Growth	2.06 (12/1978)	5.42	11.00 (12/1999)
U.S. Large Cap Balanced	1.23 (12/1978)	2.83	5.21 (12/1999)
U.S. Large Cap Value	0.87 (12/1978)	1.89	3.31 (12/2000)
U.S. Small Cap Growth	1.73 (12/1978)	4.15	5.77 (12/1999)
U.S. Small Cap Balanced	0.99 (12/1978)	2.26	2.72 (12/1999)
U.S. Small Cap Value	0.69 (12/1979)	1.56	2.11 (12/1997)

Source: Data based upon Russell Indexes for U.S. stock asset classes, as accumulated and analyzed by ScholarFi Inc. All measures of overvaluation/undervaluation are estimates, only. An adjustment is then made to available month-end data, derived from Russell Index data site, for changes in prices over subsequent period to date shown, using Vanguard funds data. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RETURNS. For educational purposes only. No warranties are provided as to the accuracy of the data provided.

Where does all of the foregoing leave us? Permit me to share a few of my own conclusions:

First, I believe that the U.S. stock market has likely reached a point of overvaluation, relative to historic norms. Perhaps in the range of 0% to 40% overvalued. (The data, for the reasons stated above, does not permit in my view a closer approximation of values.)

Second, if you tilt your U.S. equity allocation in your portfolios toward value and small-cap stocks (on a diversified basis), it does not appear that value and small-cap stocks are as significantly overvalued as large-cap growth stocks might be. Hence, some comfort should be taken that the value and small cap risk premia are likely to deliver, with a high degree of probability (but not certainty), higher returns in the U.S. equity portion of a portfolio over the long term (15 years or longer).

Third, I don't believe that valuation levels have reached such stellar heights that investors should flee the U.S. stock market, nor any particular asset class. (I'm not convinced that "market timing" in the form of "tactical asset allocation" can consistently add value, over and above a consistent exposure to the value and small cap risk premia.)

What do you think?