Stock Market Valuation Looks High Based On Earnings Yield Model
It’s widely known that valuation metrics for the stock market are weak as timing signals for the short term. Periods of extremes tend to offer better odds for guesstimating longer-term performance. The crucial question, as always, is whether the implications of history, which are never exact, still apply today?
The subject is timely as the trailing earnings yield for the S&P 500 Index continues to slide below the recently rising US 10-year Treasury yield. The January estimate for the S&P earnings yield is roughly 3.30%, well below the 10-year yield, which trades at around 4.60% in mid-afternoon trading today. The gap in favor of the 10-year note suggests that the long-run risk premium for stocks is negative.
That’s a conspicuous change. The spread had been positive, favoring equities, since 2009, when the market rebounded sharply from the financial crisis. But this measure of the equities risk premium fell into negative terrain in 2023 for the first time in 14 years and has continued to trend lower.
Classic value-oriented strategies suggest that a negative premium warrants an aggressively defensive position for stocks. But there’s a growing pool of research that raises doubts about the efficacy of old-school valuation rules for managing equity allocation weights. A study by Goldman Sachs, for instance, reports that “history…shows us that valuations alone are not a good signal for exiting the market. Since US equities first entered the ninth decile of valuations in November 2013, the S&P 500 has rallied about 300%. Since they entered the 10th decile of valuations, equities have returns over 200%.”
The CAPE ratio (Cyclically-Adjusted Price-to-Earnings Ratio), a popular measure of equity market valuation, also exhibits disappointing results on a short-term basis. “The Shiller CAPE has historically explained only 6% of the returns for the next calendar year,” Goldman finds.
Are valuations worthless? No, but it’s only one factor in the toolkit and should be used prudently and perhaps differently, depending on the investor and portfolio strategy. Adding context from other perspectives is valuable, and on that score history suggests price trend is useful as a complimentary factor.
The US stock market’s valuation looks stretched, but there’s room for debate about whether that will be a meaningful factor anytime soon. One reason: the S&P 500’s trend remains bullish, based on the index’s 50-day average holding well above its slower 200-day counterpart, for example. Monitoring and evaluating the trend factor requires more than one set of moving averages, but the 50-/200-day is good first approximation. Although trend is far from flawless, the empirical record suggests it’s a useful tool for assessing the near-term risk outlook.
Meanwhile, the richly valued US stock market suggests trimming equity weights for investors with a low risk tolerance, a short time horizon, and/or portfolios with allocations in stocks that are well above targets. But as long as trend is signaling higher prices ahead, using valuation as a timing signal in isolation should be viewed cautiously.
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