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: bear@argi.net.
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: https://www.mltpl.com/shiller-pe. 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:
Source: https://www.lynalden.com/shiller-pe-cape-ratio/
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:
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 “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 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)
Email: bear@argi.net
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: bear@argi.net.
[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)
