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Slide 1 - How overvalued is the Stock Market? Gaetan Lion, February 26, 2022
Slide 2 - 2 Here is a graph that is not that informative Source: Yale -Shiller As of January 2022 (most recent data point at time of writing), the Shiller PE ratio (that captures inflation adjusted earnings over past 10 years) was at 35 within striking distance of the all time high level of 44 during the dot.com Bubble. Given the high PE ratios, investors fear the S&P 500 is way overvalued. And, a “revert to the Mean” correction is due (entailing a – 20% market correction based on PE or - 40% one based on Shiller PE). The market is undergoing a correction due to numerous fundamental factors (Fed ready to raise rates, Russian invasion of Ukraine, ongoing supply bottlenecks, stubbornly high inflation). However, this PE ratio mean reversion analysis is incomplete. Also, I am not a big fan of the Shiller PE ratio because it penalizes the market for rapidly growing earnings over the past decade.
Slide 3 - 3 Source: Yale – Shiller, H.15 When comparing the S&P 500 to 10 Year Treasuries, a very different picture emerges. The top graph inverses the S&P 500 PE ratio to generate an Earnings Yield that we simply call EP. And, it divides this S&P 500 Earnings Yield by the 10 Year Treasury yield. And, we look at this multiple or ratio going back to 1962. The bottom graph looks at the spread of the market Earnings Yield minus the 10 Year Treasury yield over the same period. Both graphs tell the same story. Relative to 10 Year Treasuries, the Market is undervalued. At this stage, we can’t tell if it is a case of the market being undervalued or Treasuries being even more overvalued than the Market.
Slide 4 - 4 Source: Yale Shiller, H.15, FREDS The Market is really cheap vs. any bond category As of January 2022, the market Earnings Yield (EP) is 2.2 times as high as 10 Year Treasury yields (way higher than the long term average of 1.3). The spread between the two at 1.73% is a lot higher than the long term average of 0.27%. 10 Year Treasury yield would have to increase by 1.47 percentage point for the Market Earnings Yield and 10 Year Treasury yield to be aligned with their long term average spread. The story is exactly the same for 30 Year Treasury, Moody’s Baa corporate bonds, and S&P BB and B rated corporate bonds. As reviewed, the Market is very cheap relative to any type of bonds. This may still indicate that bonds are way overvalued, even more so then the Market. Time series are based on monthly frequency.
Slide 5 - 5 The Market Risk Premium above 10 Year Treasury is a lot higher by historical standard than for any bonds Source: Yale Shiller, H.15, FREDS As of January 2022, the Market Earnings Yield (EP) is 2.07 percentage points higher than the 10 Year Treasury yield. This level is 0.56 standard deviation above its long term average (0.88%) corresponding to the 71st percentile of this specific time series distribution. For all the reviewed bonds, the risk premium is much below their respective long term average. And, these bond risk premiums fall within the bottom quartile of their respective time series distribution. This is another indication that the Stock Market is a lot cheaper than the Bond Market. The specific time series in this case starts in 1997 using monthly data. This is to specify the same time series for all bonds (the BB and B time series were the shortest starting in 1997). Current means January 2022.
Slide 6 - 6 Source: Yale Shiller, H.15, FREDS, BLS Relative to Inflation both the Markets and Bonds are much overvalued The specific time series in this case starts in 1997 using monthly data. This is to specify the same time series for all bonds (the BB and B time series were the shortest starting in 1997). Current means January 2022. Inflation is the 12 month change in the Consumer Price Index. It has recently jumped to 7.5%. And, the capital markets have much lagged this spike in inflation. Back in early 2021, the Federal Reserve stated that any inflation spike would be transitory. But, 12 mth change in inflation has been at or above 5% since May of 2021, and pretty much rising ever since. As of January 2022, the 12 mth change in CPI is 7.5%. This is the highest inflation rate since the Paul Volcker years in the late 70s and early 80s.
Slide 7 - 7 Relative to 10-Year Inflation Expectation both the Markets and Bonds are still overvalued Source: Yale Shiller, H.15, FREDS The monthly data starts in 2003. This is as far back as Inflation Indexed Treasuries go. The latter allowed us to derive 10-Year Inflation Expectation. The overvaluation is not as pronounced as when focusing on the 12-mth change in inflation. Vs. Inflation Expectation the Markets and Bonds related spreads are 3 or more standard deviations below the average, as shown on the previous slide. When focusing on the 10-Year Inflation Expectation, the spreads are less than 2 and often close to 1 standard deviation below average. While the recent Inflation rate is very high by historical standard at 7.5%. The 10-Year Inflation Expectation at 2.45% is reasonable and close to the long term average. This explains why the overvaluation is so much less pronounced when focusing on 10-Year Inflation Expectation. In both cases, the Market is typically much less overvalued than most of the bonds.
Slide 8 - 8 Relationship between S&P 500 Earnings Yield and Inflation measures Source: Yale – Shiller, BLS. Going back to 1961 Source: Yale – Shiller, BLS. H.15. Going back to 2003 EP at 3.83% vs. a 7.5% 12 mth change in inflation is much below the regression line that comes up with an estimated EP of 9.00%. Notice this regression using data going back to 1961 is quite explanatory with a reasonably high R Square of 0.64. EP at 3.83% vs. a 2.45% inflation expectation over next 10 years is much below the regression line that comes up with an estimated EP of 5.33%. This model has a short time series (back to 2003 due to limited data on inflation indexed Treasuries) and is not that explanatory with a low R Square of 0.27.
Slide 9 - 9 Current Inflation Rate in Historical Context Source: BLS You have to go back to the early 1980s, in the middle of the Paul Volcker years to encounter inflation rate as high (and higher) than the current level of 7.5%.
Slide 10 - 10 Considerations as of January 2022 Caveat. As we speak, the Market is undergoing gyrations due to the Russian invasion of Ukraine that is not captured in this analysis relying on data that cut off in January 2022. The Market is much undervalued relative to any bond types. When looking at long term historical averages, the current Market Earnings Yield (EP) is a lot higher than bond yields; The Market could withstand a substantial increase in interest rates to restore the historical equilibrium between the Market Earnings Yield (EP) and bond yields. Thus, an increase in rates may not necessarily exacerbate the current market correction/gyration related in good part to the Russian invasion. In our previous study, we focused on the relationship between interest rates and the Market. And, as reviewed this relationship is extremely weak; The Market is much overvalued relative to any Inflation measures (historical or prospective). Its current EP at 3.83% is low relative to inflation measures. As the scatter plots show on slide 8, the regression model estimates EP at 9.00% given a 12 mth inflation rate of 7.5%, and an EP of 5.33% vs. a 10 year inflation expectation of 2.45%. The discrepancy between the EP and the 10 year inflation expectation is more concerning because that inflation measure is reasonable and close to historical average. This is unlike the 7.5% spike in inflation over the past 12 mth that could abate shortly. Focusing on the 10 year inflation expectation measure, it would entail a potential market correction of: 3.83%/5.33% - 1 = - 28%. Notice that this regression model is not that explanatory (R Square 0.27). So, there is much uncertainty around this potential market correction estimate. Nevertheless, the current EP of 3.83% is 1.4 standard error below the estimate of 5.33%, indicating that 92% of this regression model residuals are higher than for this current observation. That is pretty far out on the left-tail.
 

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