US Equities: Resilient Force or Case Study in Denial?

The second argument that the market is in a bubble is more sophisticated and data-based, at least on the surface. In short, it accepts the argument that stocks should increase as earnings go up, and that looking at the multiple of earnings that stocks trade at is a better indicator of market timing. In the graph below, I graph the PE ratio for the S&P 500 going back to 1969, in conjunction with two alternative estimates, one of which divides the index level by the average earnings over the prior ten years (to normalize earnings across cycles) and the other of which divides the index level by the inflation-adjusted earnings over the prior ten years.

Note that on October 1, 2019, all three measures of the PE ratios for the S&P 500 are higher than they have been historically, if you compare them to the median levels, with the PE at the 75th percentile of values over the 50-year period, and normalized PE and CAPE above the 75th percentile. Proponents then complete the story using one of two follow up arguments. One is that mean reversion in markets is strong and that the values should converge towards the median, which if it occurs quickly, would translate into a significant drop in stock prices (35%-40% decline). The other is to correlate the l PE ratio (in any form) with stock returns in subsequent periods, and show that higher PE ratios are followed by weaker market returns in subsequent periods.

If you are convinced by one of the arguments above that stocks are over priced and choose to sell, you face a question of where to invest that cash. After all, within the financial market, if you don’t own stocks, you have to own bonds, and this is where the ground has shifted the most against those using the mean reversion argument with PE ratios. Specifically, if you consider bonds to be your alternative to stocks, the drop in treasury rates over the last decade has made the bond alternative less attractive. In the graph below, I compare earnings yields on US stocks to T.Bond rates, and include dividend and cash yields in my comparison:

Download raw data on yields and interest rates

In short, if your complaint is that earnings yields are low, relative to their historic norms, you are right, but they are high relative to treasury rates today. To those who would look to real estate, a reality check is that securitization of real estate has made its behavior much closer to financial markets than has been historically true, as can be seen when you graph capitalization rates (a measure of required return for real estate equity) against equity and bond rates.