Relative Valuation Models
The two absolute valuation models work well when yields remain constant, but in the real world prices can vary wildly around slower-moving fundamentals, such as dividends and earnings. As a result, it is also important to pay attention to relative valuations. Model 3 uses price divided by average 10-year real earnings, also called the cyclically adjusted PE ratio, or CAPE, to model expected returns. CAPE, or its inverse, the cyclically adjusted earnings yield plotted in Figure 2, captures equity prices relative to a smoothed economic anchor. Countless other relative valuation metrics relate prices to other anchors, and they all tell a similar story. We focus our attention on four of the most commonly cited, as listed in Table 1.
Converting each of these models into a return forecast requires comparing the equity market's current price level to a benchmark, typically the long-term average value of the respective ratio. Figure 3, Panel A, shows each of the four metrics compared to its long-term average for the period 1871–2015. Panel B provides the same four-ratio comparison focused on the last 15 years. Values greater than zero indicate that the market is overvalued, or expensive, and values less than zero indicate that the market is undervalued, or cheap. The figures succinctly illustrate that these four metrics often tell the same story—and today that story is that the U.S. equity market is overvalued!
The charts in Figure 3 also highlight two distinct shortcomings of valuation ratios. The first is that they cannot be relied on for guidance in timing the market. Take, for example, the early 1990s. All of these measures would have indicated that the market was becoming overvalued. That may very well have been the case, but anyone jumping ship then would have missed out on one heck of a bull market! As Paul Marsh, Professor Emeritus at the London School of Business, points out, "The exact timing of it [a market reversal] is extraordinarily elusive" (Pleven, 2015). Simply knowing a market is overvalued tells us nothing about when it is expected to revert to reality.