With all the warnings about excessively high valuations investors have been getting from gurus and the financial media, it’s not a surprise that a frequent conversation I’ve been having with investors starts out something like this: I’ve got cash to invest, but the market is at such a high level I think I should wait for a market correction before putting it to work. What should I do?
To address that question, I begin by first noting that, while U.S. equity valuations are at historically high levels, this is neither the case for non-U.S. developed markets or emerging markets.
Their valuations are much lower, and with the risk-free rate at historically low levels, this makes their equities look relatively more attractive. For example, while the CAPE 10 ratio for the U.S. market currently is about 30, it’s about 18.5 for EAFE market equities (almost 40% lower), and only about 14 for emerging market equities.
Having established that valuations—and, therefore, expected returns—around the globe are quite different, I’ll briefly revisit some insights on why the high level of the CAPE 10 in the U.S. may not be signaling overvaluation.
To begin, the Shiller CAPE 10’s historical mean is 16.8. The data set goes back to 1880, and it includes economic eras in which the world looked much riskier.
For example, for a significant part of the period, there was neither a Federal Reserve to dampen economic volatility nor an SEC to protect investor interests. The presence of both organizations has helped make the world a safer place for investors, justifying a lower equity risk premium and, thus, higher valuations.
Another reason for the CAPE 10 to rise over time is that the U.S. has become a much wealthier country. As wealth increases, capital becomes less scarce. All else being equal, less scarce assets should become less expensive, resulting in higher valuations.
There’s also an issue related to accounting changes. In 2001, the Financial Accounting Standards Board (FASB) changed the rules regarding how goodwill is written off. Prior to 2001, GAAP required goodwill amounts to be amortized—deducted from earnings as an incremental noncash expense over a 40-year period. But in 2001, FAS 142 was introduced.
Since that time, companies have been required to annually test goodwill for impairment. If assets are no longer deemed to be worth the prices paid, companies must immediately write down goodwill. What’s more, the requirement for annual impairment testing doesn’t just apply to goodwill, but to all intangible assets, and, per FAS 144 (issued a few months later), all long-lived assets.