By Bill Rearden
On March 14, 2016, I gave a presentation at the Society of Actuaries Investment Symposium on, “Are U.S. Equity Markets Overvalued?” Nobel Laureate Robert Shiller’s Cyclically-Adjusted-Price-Earnings Multiple (CAPE) is often the reference for U.S. equity market valuations. Based on Shiller’s data that dates back to 1871, the CAPE has had a historical average of 17 with peaks prior to major corrections of 32 and 40 in 1929 and 2000, respectively. The CAPE reached 27 in June of 2015 and currently stands near 24 suggesting the market is overvalued.
My presentation addressed three major headwinds and tailwinds influencing U.S. equity markets today.
The three major Headwinds for equity markets are:
- Historically a CAPE above 20 has yielded negative real price growth over the next 10 years.
- The Federal Reserve in the past has made policy mistakes that have hurt the U.S. economy. As the Fed begins raising interest rates, uncertainties from past mistakes add more volatility to the market.
- The most interesting headwind is the aging demographic, which means that over the next decade, the demand for U.S. equities will wane as baby boomers settle into retirement. Price-Earnings multiples are projected to drop below 10 in the next decade from around 20 today.
The three major tailwinds for equity markets are:
- The Federal Reserve forecasts medium-term economic growth near and slightly above the annual 2 percent trend rate, along with better unemployment rate projections, and below 2 percent target inflation. These are favorable for equity markets.
- U.S. companies are becoming more efficient; annual operating margins improved by 9 percent in 2015 and are expected to average 11 percent over the next five years.
- The U.S. economy continues to shift away from the manufacturing industry to the service industry. Information Technology makes up more than 20 percent of the S&P 500 index, and rapid growth from this sector is helping to raise valuations across the index.
Prior to the market crash of 1929, the market began trending downward as investors began adjusting their price expectations to slowing economic data. The market declines in January 2016 were triggered by consecutive months of U.S. manufacturing declines and slower global economic growth. The major behavioral finance lesson learned from the 1987 crash was that investors back away from markets as a downtrend emerges. Waiting for signs of a reversal can put stress on trading systems and lead to even sharper price drops.
Yes, the market is overvalued when making comparisons with historical valuations. However, the underlying economic shift from manufacturing to service makes these types of comparisons much less practical. As long as the economy is expected to grow, innovation from the Information Technology sector can generate more unpredictable upside profitable opportunities than manufacturing was historically capable of.
Bill Rearden is co-founder and strategy consultant at Ironbound Consulting Group. He can be contacted at bill@ironbcg.com