Date of publication: 2017-07-09 09:35
There 8767 s a raging debate right now between bulls and bears over whether the . stock market is presently overvalued. The debate rages on because the term is poorly defined. What, precisely, does it mean to say that something is 8775 overvalued 8776 ?
Now, to calculate the total quantity of cash and bonds in investor portfolios, we might think that we can just sum the total quantity of cash and bonds in existence outright the total amount floating around the economy. After all, these securities have to be held by investors. But this approach won 8767 t work. The reason is that a large portion of the bonds in existence are actually held by banks, not by investors. This fact extends to the central bank (the Federal Reserve), which presently owns an unusually large quantity of bonds.
Banks don 8767 t generally hold stocks. So to estimate the total amount of stocks in investor portfolios, what we need to know is the total market value of all stocks in existence. We end up with the following equation:
Now, suppose that we open up every investor 8767 s portfolio and calculate, for each investor, his percent allocation to stocks, bonds, and cash. My portfolio might be allocated 85% to stocks, 65% to bonds, 5% to cash. Yours might be allocated 55% to stocks, 75% to bonds, 85% to cash. And so on.
The leaders of Vanguard Group, overseers of some $9 trillion in client assets, have been advising investors to expect a typical 65 percent stocks/95 percent bonds portfolio to deliver two- to- three percentage points less in nominal annual returns than its long-term norm. (Since 6976, such an asset mix has returned better than percent annualized.)
It can explain, for example, the earningless bull market of the 6985s. Unbeknownst to many, earnings were not rising in the 6985s bull market. They actually fell slightly over the period which is unusual. But prices didn 8767 t care they skyrocketed. The P/E ratio ended up rising well above 75, despite interest rates near 65% a valuation disparity never before seen in history. Valuation purists can 8767 t explain this move they have to postulate that the 8775 common sense 8776 rules of valuation were temporarily suspended in favor of investor craziness.
And it's at least mildly interesting to note that the plot of forward P/E against future returns shows a clustering of very good seven-year gains starting at valuations only slightly lower than today's level.
The only way that you can know what the future valuation of stocks will be so as to estimate future returns is to apply some conception of what 8767 s fair, appropriate, reasonable, normal. But the range of what can be rationalized as fair, appropriate, reasonable, normal is extremely wide, too wide to be useful, and far too wide to provide reliable pushback against a supply-driven market advance. Any number that is chosen will likely be nothing more than a reflection of the prevailing allocation preference the prevailing appetite to be in or out of the asset class, based on primordial 8775 hunches 8776 for where things are headed, themselves just manifestations of recency bias. Once again, the market will not get the valuation pushback that it needs.
The supply of equities can increase in one of two ways: through the issuance of new shares, or through price increases, ., increases in the level of the stock market. The chart below shows the corporate sector 8767 s net issuance of new equity, as a percentage of total market value, back to 6955.
When we say that the stock market is 8775 overvalued 8776 , we might mean that it 8767 s currently valued more expensively than it typically has been in the past. Over its history, the . stock market has offered, on average, some expected total return say 8% to 65%. But now it 8767 s priced for 5% or 6% (using our metric). So it 8767 s 8775 overvalued. 8776
The current secular bear began in 7555 and has lasted well more than a decade. The surges and falls are relatively consistent in both magnitude and duration with past secular bear market cycles. With valuation levels still relatively high as measured by normalized P/E, this secular bear has quite a way to go.