Is the Market Overvalued?

We are often asked whether or not we believe the U.S. equity market is overvalued. Our answer is a resounding "yes!" Here’s why:

Between 1968 and 1998, the Price/Earnings ratio on the S&P 500 averaged 15.6x. Today it stands at 32.1x. Rather than just saying, "that’s too high", let’s look at some of the arguments that have been used to justify this lofty multiple. In other words, what would have to be true in order for this valuation to be fair or low.

One of the better arguments that we have seen is that earnings are understated because old accounting rules are no longer appropriate for the "new economy." More specifically, in the new economy, knowledge, brands and human capital ("talent") are much more important drivers of value creation than they have been in the past (arguable, but let’s accept it as legitimate for now). However, even though these assets produce income across multiple time periods, many of the investments associated with them (for example, R+D spending, advertising, and training costs) are expensed in the year they are incurred, rather than capitalized and depreciated over time (as one would do when spending cash on a machine or building). The net effect of this is a serious understatement of annual earnings. If this is true, the P/E ratio may not be too high after all.

On its face, this is a good argument. However, what it neglects is another aspect of the "new economy" that undoubtedly offsets some of the earnings understatement it claims is occurring. We refer, of course, to the substantial increase in the use of stock options in recent years to compensate some or all of a company’s employees. While the details are too technical to go into at length, the key point is that the full cost of issuing and exercising these options does not show up as an expense in a company’s profit and loss statement. As a result, the use of stock options in companies’ compensation plans has resulted in a substantial overstatement of their earnings. One of the most popular examples of this argument is Microsoft, and an extensive if somewhat over-wrought discussion of the earnings impact can be found on Bill Parish.

Another argument that has been used to justify today’s high market P/E is that the many changes wrought by the "new economy" have fundamentally raised the rate at which the U.S. economy can grow without triggering inflation. In other words, if you look at the growth side of the equation, the P/E to growth (or PEG) ratio for the market is not overvalued (that is, it is less than 1.5 to 2.0). Rather, the current market P/E represents the opportunity "to buy growth at a reasonable price." Okay, let’s test this.

First, let’s look at the growth of after tax business profits in the United States (as described in the 2000 Economic Report of the President (available at http://www.gpo.gov). Between 1959 and 1998, after tax business profits grew at a compound rate of 7.2% per year. But let’s be a bit more aggressive, and date the beginning of the new economy right about the time this long bull market began, in 1982. From 1982 to 1998, after tax business profits have grown by 9.5% per year. Now let’s use this rate to calculate a PEG ratio for the market as a whole, and let’s use Peter Lynch’s approach, and add the current dividend yield on the S&P 500 of 1.19% to the growth rate. The equation looks like this: P/E Ratio divided by (growth rate plus dividend yield times 100), or 32.06/10.69. The resulting PEG ratio is about 3.00, which is well into the overvalued range.

Ah, but some will say, remember that corporate profit numbers can be distorted by outmoded accounting rules. You really have to look at the impact of the "new economy" on overall economic growth. Fair enough; let’s have a go at that too.

In the long term, the nominal growth rate of output in an economy is driven by three factors: (1) the rate at which the population is growing (a proxy for labor force growth); (2) the rate at which real output per worker (labor productivity) is growing; and (3) the rate of inflation. Over the past ten years, the population of the United States has grown by about 1% per year. The growth of labor productivity is a more interesting story. Between 1900 and 1970, real output per hour grew at an average rate of 2.3% per year. The high point during this period was the 1950s, where it reached 3.0% per year. In the 1970s, growth in output per worker declined to 1.1% per year, and in the 1980s it improved only slightly to 1.3% per year. In the 1990s, things substantially improved: over the decade as a whole, output per worker grew by 2.01% annually, while in 1997, 1998, and 1999 it grew by respectively 2.2%, 2.8% and 3.0%. What then is a reasonable rate of future growth to assume for the economy as a whole?

Let’s be aggressive here, and assume population growth of 1% per year, labor productivity growth of 3% per year, and average inflation of 3.5% per year. This gives us an expected nominal growth rate of 7.5% per year. Now let’s add to that a dividend yield of 2% per (again, let’s be aggressive), and calculate our PEG ratio. Here’s what it looks like: 32.06/9.5 = 3.37. Again, this suggests a very overvalued market. In fact, given the current P/E of 32.06, getting the PEG down to a "reasonable" value of 1.5 requires an expected earnings growth rate of about 20% per year. For individual stocks, this is undoubtedly achievable, at least for a period of time. For the market as a whole, however, it is not. Once again, the market appears overvalued.

Finally, let’s take a look at one last valuation measure, the ratio of the rate of return on the 30 year Treasury Bond to the earnings yield on the S&P 500 (which is the inverse of the P/E ratio). Given today’s long bond yield of 6.15%, and the 32.06 P/E on the S&P 500, we have bond/earnings yield ratio of 1.97x. Since 1984, this has averaged 1.4x. Again, another sign that the market is overvalued.

Does this analysis mean you should rush out and sell all your S&P 500 investments? No, it doesn’t. A great deal of research (which we’ll cover in a later issue) suggests that market timing is a very difficult game to win. The better approach, which we strongly advocate, is to (1) allocate your investments across a range of asset classes, (2) using low cost index funds, and (3) dollar cost averaging, and (4) regularly rebalance your investments to maintain your target portfolio weights. For example, a portfolio that contains a mix of U.S. equity, European equity, U.S. bond and Non-U.S. bond index funds will probably be down far less than a pure S&P 500 portfolio when the latter’s valuation inevitably returns to normal levels.

| Hedging Exposure to an Overvalued Market (Part 1) | Is the Market Overvalued? | Recommended Portfolio Performance |