Is the Market Overvalued? Depends on How You Frame it…

/Is the Market Overvalued? Depends on How You Frame it…

Is the Market Overvalued? Depends on How You Frame it…

By | 2017-08-18T17:01:37+00:00 July 9th, 2014|Uncategorized|25 Comments

People love to talk about the stock market. It’s practically a law of human nature.

What is the market telling us? Where is it going from here? Should I get in? Out? Is it fairly valued?

We don’t really know where the market is heading and are fairly confident nobody else knows either, nonetheless, its fun to pontificate on the subject.

Predictably, perhaps, when the Dow Jones surpassed 17,000 for the first time recently, it spurred a flurry of articles in the financial press. Seemingly everyone has a view as to whether the bull run can continue.

Although there are a number of lenses useful for assessing market conditions, many feel that Robert Shiller’s CAPE (Cyclically-adjusted PE ratio) index is among the more reliable yardsticks for measuring market valuations (we explain the CAPE ratio here). Note: CAPE is not a superhero; there are other ways to value the market).

Bob Shiller recently discussed his index, expressing concern about current valuations (we examined this about a year ago).

Is there a basis for concern?

Based on a review of the Shiller CAPE index (shown below – data from Shiller’s website and the Federal Reserve website), the market certainly appears to be expensive. Currently the CAPE index is in the 93rd percentile based on the past 133 years of data!

CAPE Index

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

We prefer equity “yield” metrics to multiples, since yield formats make it easier to compare across other asset classes, such as REITs or bonds. The inverse of the CAPE index (1/CAPE) can be thought of as an “earnings yield.” This inverse is the cyclically-adjusted earnings over the current price. Here is the historical graph of 1/CAPE (now a “lower” number is considered more expensive).

1/CAPE

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

This is obviously the same basic framework as with multiples, but it does provide some additional perspective as we now can make more directly compare equity yields with yields on other asset classes.

Again, based on the CAPE and 1/CAPE ratios, the market is surely expensive. No argument there.

But what about alternatives to investing in stocks?

What yields can be had in other asset classes? Bonds seems like a reasonable place to start. Let’s compare our stock market yield versus what we can get on a 10-year treasury bill.

If we take the “earnings yield” (1/CAPE) and subtract the inflation adjusted 10-year U.S. Treasury yield, we can examine how expensive the market is relative to the bond alternative (a stock investor would prefer a higher spread, all else being equal). The inflation adjusted yield is calculated as the 10-year yield minus inflation, where inflation is measured as change in consumer CPI year over year.

The spread between stocks and bond yields is presented below:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The figure above is not screaming overvaluation for stocks. The current “excess” yield over the inflation-adjusted US Treasury rate does not appear too high, when compared to historical excess spreads.

In fact, the current value of 3.13% is only slightly below the median value of 3.51%, falling in the 46th percentile.

So if bonds are your risk-free alternative to stocks, then the market does not appear to be extraordinary expensive on a relative basis.

That being said, who knows where the market will go from here!


  • The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
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About the Author:

Jack Vogel
Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.

25 Comments

  1. Doug July 9, 2014 at 7:29 pm

    Great stuff as usual. Unrelated question – what language/platform do you use to run your quant value backtests? R? Matlab? VB? Python? C++? Bloomberg? Just curious.

    • Wesley Gray, PhD
      Wesley Gray, PhD July 9, 2014 at 7:50 pm

      For all our academic-focused work like QV we use SAS and CRSP/Compustat, which are the “standards” for academic work.

      For trading and execution and more low-brow projects we like Bloomberg API and Excel VBA.

      • Tom Rinaldi July 10, 2014 at 1:44 pm

        In the end you can only ride this yes until it changes trend, yes? Stocks being fair against bonds when bonds are being held down by governments doesnt tell us a ton. Have you ever seen a CAPE analyst on sectors. Things like metals for instance may be cheap to their trailing inflation adjusted earnings averages.

          • Wesley Gray, PhD
            Wesley Gray, PhD July 10, 2014 at 5:22 pm

            thx for the link, Tom

          • Tom Rinaldi July 10, 2014 at 5:36 pm

            You know the answer. Ride the 200 day. Your post on whether stocks being expensive or cheap being a guide to trading was a great one. It can predict long term returns but it’s all about the path. One doesn’t need to hold for twenty years right.

          • Tom Rinaldi July 10, 2014 at 5:40 pm

            If you are against expensive on CAPE and bad trends I guess you own energy and emerging markets here. And maybe Europe?

          • Wesley Gray, PhD
            Wesley Gray, PhD July 10, 2014 at 5:44 pm

            I’m actually not against it, per se. Just seems like any timing based on valuations doesn’t work. Long term MA looks like the way to go

          • Tom Rinaldi July 11, 2014 at 11:32 am

            I didnt mean to suggest you were against CAPE. I was more saying if someone wants to adhere both to a good trend and reasonable CAPE valuation, they would at this point probably be looking at energy stocks and emerging market stocks.

          • Wesley Gray, PhD
            Wesley Gray, PhD July 11, 2014 at 11:43 am

            yup, makes sense.

        • Wesley Gray, PhD
          Wesley Gray, PhD July 10, 2014 at 5:29 pm

          Trend following seems to be king when it comes to tactical allocation, at least historically.

          Even with tampering, the treasury is still the “baseline” opportunity cost for any investment and you should still receive the baseline plus a spread, where the spread is the benefit to buying risk. And if you think everything is overvalued and expensive you are stuck between a rock and a hard place. On one hand, you can capture higher returns by taking on an equity premium, but your overall expected returns will still be low in the current environment (ie. rf + equity premium), or you can put the money under a mattress earning a negative inflation% each year and wait for a market blow up and take advantage of a higher equity premium. The cost/benefit gets real tricky in the current situation. Wish I knew the answer

  2. Isaac Presley July 9, 2014 at 7:40 pm

    How do you get a 1/CAPE – 10tsy spread of 3.13%. Per shiller data as of July: 1/25.96 – 2.64 = 1.2%

    • Wesley Gray, PhD
      Wesley Gray, PhD July 9, 2014 at 7:51 pm

      Isaac, will get back to you with answer.

      • Jack Vogel
        Jack Vogel, PhD July 10, 2014 at 5:32 pm

        Isaac, good catch. We subtract the inflation-adjusted 10-year yield in order to compare the real earnings yield to the real 10-yr yield.

  3. shortboard July 10, 2014 at 3:19 am

    ” as we now can make more directly compare equity yields with yields on other asset classes.” Can you really compare equity yields to say bond yields like that? The duration of the instruments is completely different.

    • Wesley Gray, PhD
      Wesley Gray, PhD July 10, 2014 at 7:07 am

      Thanks for the question.

      The duration on equity and a 10-year bond are different–no doubt–, and the analysis is not saying that equity yields should EQUAL 10-year bond yields. However, that doesn’t mean you can’t look at the spread, or the equity premium, as a form of pricing.

      In asset pricing theory, expected returns are always roughly equal to the risk-free + some risk premium. The benefit to holding risk is how much more you can get by holding onto equity or other risk assets. All the analysis is showing is that the equity premium does not seem extremely high based on historical standards.

      • shortboard July 10, 2014 at 7:15 am

        Hi Wesley

        Hussman writes: “Among the problems with these typical approaches (equity risk premium approaches often used on wall street) is that stocks are not 3-month or 10-year instruments, but have a duration that is essentially the inverse of the dividend yield (so at present, the duration of stocks is roughly 50 years, compared with a 10-year Treasury, which has a duration closer to 7 years). So the appropriate “risk free” return in these estimates should really be either a Treasury yield of equivalent maturity – none which are available, or at least an estimate of the average expected short-term risk free rate expected over the same horizon. Needless to say, estimates of the equity risk premium get a false benefit if you use today’s unusually suppressed, short-duration risk-free rates.”

        On a different note: thx for writing “Quantitative Value” with Carlisle. It really is a brilliant book. Everyone reading this should buy it. http://www.amazon.com/Quantitative-Value-Web-Site-Practitioners/dp/1118328078

  4. SX July 12, 2014 at 2:47 pm

    Can you help me understand why 1/cape is real earning yield instead of nominal earning yield ?Thanks

    • Wesley Gray, PhD
      Wesley Gray, PhD July 12, 2014 at 2:53 pm

      Sure, CAPE stands for cyclically adjusted price-earnings. Part of the cyclical adjustment includes an inflation adjustment on the earnings. So CAPE, by design, is already in “real” terms

      • SX July 12, 2014 at 10:33 pm

        the name, CAPE, seems to suggest that it is real!! But how do you think about this following argument: the price is adjusted to reflect today’s price, and the bottom of CAPE is the average 10-yr earnings with inflation adjusted to reflect actual earnings at today’s price, thus the 1//CAPE (today’s earnings/today’s price) is nominal earning yield not real earning yield!

      • SX July 12, 2014 at 10:36 pm
  5. dph May 5, 2015 at 3:14 am

    Are there any timing strategies where it shows that the change in bond yields can predict equity returns in advance?

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