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Monday, July 19, 2021

Da Bear's Perspectives: An Update on Asset Class Valuations


Da Bear’s Perspectives

Volume I, No. 2  —July 14, 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:



An 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? What should I do, if the market is overvalued?

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!

Executive Summary

Stock markets around the world have rebounded dramatically since March 2000, and many stock indexes are at all-time 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.

Evidence exists that all three major asset classes – U.S. stocks, U.S. bonds, and U.S. real estate – are overvalued at present.

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, or longer.

Several of ARGI’s investment strategies appear to be appropriate as a long-term addition to investment portfolios, and suitable for utilization in the current market environment.

The U.S. Stock Market (Overall) Is Substantially Overvalued

According to my own review of asset class valuations, as of early July 2021, 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, 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 includes 500 of the largest U.S. companies on a cap-weighted basis. By using an approach that levelizes 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.

As this chart indicates, the Shiller CAPE10 illustrates the present over-valuation of U.S. stocks, relative to the mean:

Source: Retrieved July 13, 2021.

The historic mean of the Shiller CAPE10 valuation ratio is 16.82.[i] Due to changes in accounting practices and standards that occurred around 2003, and other factors, some financial academics argue that a more reasonable “mean” should be around 20-26.

The maximum value of the Shiller CAPE 10 valuation ratio was 44.19, which occurred in December 1999. Only in 1999-2000 was the valuation ratio higher than it is as of July 13, 2021 – when it stood at 38.52.[ii]

The Shiller CAPE ratio is a good indicators for long-term forecasts,[iii] and may be one of the most statistically significant predictors of long-term U.S. stock market returns.[iv] The following chart, 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 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.

Why Have Stock Prices Gone So 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.[v] 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.[vi]

As set forth by ISH Markit, this chart indicates that projections of future economic growth, around the world, are quite strong:

Still another reason, related to investor psychology, is the rise of the social media hype of certain stocks, such as Gamestop, AMC, Blackberry, Bed Bath & Beyond, and Clover. 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 “meme 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 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.[vii]

Similarly, Campbell and Shiller demonstrated that high valuation multiples such as aggregate book-to-market or earnings-to-price ratios, which signal low current prices, have been found to forecast high subsequent stock market returns.[viii]

However, mean reversion is not universally accepted in academic circles.[ix] 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. Many 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.”[x]

Overall, I believe mean reversion – over the very long term – for broad asset classes, is highly likely to occur (at least partially, and many times fully). 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 7 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.

The Expected Returns of Various Asset Classes

There are many opinions about the future returns of stock asset classes. As you read the following, be aware:

The information presented below 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.

Some estimates of 10-year expected average annualized returns for various asset classes are undertaken by several investment firms. This chart summarizes their recent projections:

              U.S. large company stocks:              1.7% (RA) (strong overvaluation exists)

                                                                        2.4% to 4.4% (VG)

                                                                        5.4% (SSGA)


              U.S. small company stocks:             3.5% (somewhat strong overvaluation exists) (RA)

                                                                        5.6% (SSGA)


              Foreign developed markets:              6.1% (RA) (slight overvaluation exists)

                                                                        6.3% (Euro are only) (SSGA)

                                                                        4.7% (Pacific area only) (SSGA)


              Global equities:                                5.2% to 7.2% (VG)

                                                                        5.4% (SSGA)


              Foreign emerging markets:              7.6% (very slight overvaluation exists) (RA)

                                                                        7.3% (SSGA)


              Commodities:                                    1.5% (overvaluation exists) (RA)

                                                                        4.0% (SSGA)

[Projections above include data from Research Affiliates (RA) as of June 30, 2021 as derived from its Asset Allocation Interactive and Smart Beta 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 March 31, 2021.]

Note that while the foregoing projections assume reversion to the mean occurs over a 10-year period, I would again caution that mean reversion has a greater probability of occurring over a 15-year to 20-year period of time.

Not all analysts project positive returns for stocks. For example, GMO LLC projects, over the next 7 years, -7.8% annual real (inflation-adjusted) returns for U.S. large company stocks, -8.4% annual real (inflation-adjusted) returns for U.S. small company stocks, and -2.7% annual real (inflation-adjusted) returns for international large company stocks. GMO does project that Emerging Markets Value stocks will possess an inflation-adjusted annual return of +2.7% over the next 7 years. (GMO assumes long-term inflation of 2.2% over 15 years.) [Source: GMO 7-year asset class real return forecast, as of May 31, 2021.]

From my ongoing review of several sources of information, along with my own analysis (using valuation ratios for the Russell indexes for U.S. stock asset classes over the past 40+ years), 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 10 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:          -1.9%

              U.S. large company stocks:                        4.0%

              U.S. large company value stocks:              5.8%

              U.S. small company growth stocks:           1.8%

              U.S. small company stocks:                        8.9%

              U.S. small cap value stocks:                       9.5%

(Projections reflect market prices as of the close of trading on July 12, 2021, and utilize historical and current price-book ratio data for indexes 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. One-half reversion to the mean of asset class valuations is assumed. These are projections made by Ron A. Rhoades, individually, and are not undertaken by ARGI’s investment department. 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.

Again – and I cannot stress this enough - reversion to the mean is more likely to occur over a longer time period, such as 15-20 years, than over shorter periods of time. The foregoing projections assume a partial mean reversion over 10 years, which may not occur within that period of time.

Conclusion: Yes, A Growth Stock Bubble Exists

As of the date of this writing, I conclude that we are likely in a “growth stock bubble,” similar to the 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 “” 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 low interest rates.

Please realize that none of these future asset class projections are “certain.” All of the projections set forth in this document are just estimates of future returns for various asset classes. But, ignoring the phenomenon of reversion to the mean can be dangerous.

What to do now?

In my view, you would 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.

Certain ARGI investment strategies may be of particular interest to investors, either individually or in combination, as they tend to incorporate more value stocks than growth stocks:

ARGI’s Dividend Select Portfolios

ARGI’s Factor 15 Small Cap Portfolios

ARGI’s Opportunistic Buys Portfolios

ARGI’s SmartCap™ Portfolios and ARGI’s Smartcap™ Edge Portfolios

Investors seeking a conservative approach may also consider ARGI’s Blackswan™ Portfolio.

Each of these investment strategies possess certain minimums. Factsheets on each of these, or other ARGI investment strategies, are available from your ARGI financial advisor.

Two-and-a-half years ago, I read where a prominent 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 class appears to be undervalued at present. But, a discussion of long-term changes to an investor’s strategic asset allocation may prove to be worthwhile.

Until the next time …

Very truly yours,

Ron (Da Bear)


Dr. Ron A. Rhoades serves as Director of the Personal Financial Planning Program at Western Kentucky University, where he is a professor of finance within its Gordon Ford College of Business.

Called “Dr. Bear” by his students, Dr. Rhoades is also a financial advisor at ARGI Investment Services, LLC, a registered investment advisory firm headquartered in Louisville, KY, and serving clients throughout most of the United States.

The author of the forthcoming book, How to Select a Great Financial Advisor, and numerous other books and articles, he can be reached via:

[i] Robert Shiller website, data retrieved 7/13/2021.

[ii] Id.

[iii] Keimling, N. (2015). Predicting Stock Market Returns Using the Shiller CAPE — An Improvement Towards Traditional Value Indicators? SSRN Working Paper, 1-39.

[iv] Jivraj, Farouk and Shiller, Robert J., The Many Colours of CAPE (October 13, 2017). Yale ICF Working Paper No. 2018-22

[v] Shiller, R. J. (2015). Irrational exuberance. Princeton: University Press

[vi] David Lawder, “IMF raises U.S. 2021 growth forecast to 7%, assumes Biden spending plans pass,” Reuters (July 1, 2021).

[vii] 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

[viii] Campbell, John Y., and Robert J. Shiller. 1988. “Stock Prices, Earnings, and Expected Dividends.” Journal of Finance, vol. 43, no. 3 (July):661–676

[ix] 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.”

[x] Rob Arnott, Jim Masturzo, “All Asset All Access: Long-Term Forecasts Help Identify Compelling Investments Today,” PIMCO Insights (Feb. 25, 2021)