The subject of high equity valuations has been as high on the list of worries for investors as the raging debate on the stickiness of current inflation. In our missives, we often warned about high US equity valuations in the context of possible higher rates in the foreseeable future.
So far, the market has not responded alarmingly to the valuation red flag and every attempt to reprice assets has ended in very short-lived corrections, generally less than 3%. This situation has also exacerbated the valuation gap between US stocks and international equities.
Nir Kaissar at Bloomberg raises an interesting point on whether the current high valuations are an anomaly or rather a new normal. While we are reminded of Dr. Fisher’s infamous call right before the 1929 crash of “stocks reaching a high plateau,” we are intrigued by some of the datapoints that Kaissar offers.
The Bloomberg analyst uses the Cyclically Adjusted Price Earnings ratio as a long-term valuation measure and breaks the ratio down into two historical periods: 1881-1989 and 1990 to present. Kaissar indicates that the ratio in the first historical period recurrently reverts back to the long-term average, and it spends equal time above and below the said average. However, in the more recent period, the ratio finds itself below the long-term average a mere 5% of the time.
This observation raises the question if the last thirty years of higher valuations are a new normal or a long distortion soon to be erased. Naturally, the implications of one scenario over the other are quite significant from a return expectation and allocation point of view. We should remember that equity valuations are the result of essentially three components: dividend yield (often adjusted by the buy-back yield or the capital appreciation due to corporate shares buy-backs), growth of the dividend yield and valuation multiples such as the Price/Earnings ratio.
Kaissar points out that in a scenario where dividend yield expectations might be set 1.3% with an expectation of growth set at the long-term average of 5.6%, the total return expected before expansion or compression of the multiple would be 6.9%. However, depending on what belief you have about long-term valuations - anomaly or new normal – you can expect valuations in the next ten years to contract by either 8% a year to revert to the pre-1990 environment or only 3% if you think that the post-1989 parameters are here to stay. In the more dire scenario, your total return expectation (dividend yield, dividend growth and multiple reversion) would translate in a negative 1.1% per year while the more optimistic scenario would translate in a more helpful total return of +3.9%.
There are objective reasons to believe that the valuation parameters of the last thirty years are here to stay as many fundamental elements have changed. Liquidity is higher and so are the cost of trading, interest rates are generally lower (even though they could change), equity investing is much more pervasive, and most retirement accounts are practically set on automatic equity rebalancing. Retail investors also seem to have matured and are often liquidity providers during corrections rather than being panicky liquidators.
All in all, at the risk of mimicking Dr. Fisher’s untimely call, we rest in the camp that believes in a new normal. However, this belief does not change the fact that US equities are expensive and long-term expected returns should be reduced as multiples should act as a break over the next few years.