Which Metric Is Correct?
The metrics we discuss in this article produce a diverse assortment of 10-year real return forecasts for the U.S. equity market, as Figure 5 shows. The simplest metric, the average real return over the past 100 years, produces the rosiest outlook of more than 7%. The absolute valuation metrics, which incorporate dividend yield and earnings growth, also lead to a positive, but scant, forecast of around 3.5% after inflation. The relative valuation metrics, such as market cap/GDP, CAPE, Tobin's Q, and Hussman's PE which need to be added to dividend yield and growth to capture total return, generate forecasts that are less optimistic. With the current lofty equity prices, all predict contraction of their specific multiple.
Each metric has its merits. Dividends and growth tell us what to expect companies to produce for their shareholders, and relative prices tell us what to expect from mean reversion in the price of that production. Together, they present a more complete picture of equity valuation levels, although certainly not the only one. That is why we estimate long-term equity valuation by combining both types of metrics: relative value and absolute value. We value global equity markets as the sum of dividend yield and growth in earnings, capturing market return in a constant-yield environment, as well as considering the reversion of CAPE to its long-term average.3
The choice of CAPE is not without its critics, who are quick to point out that changes in accounting rules and changes to the CPI calculation, along with the timing and benchmark issues inherent in relative valuation measures make CAPE an unreliable metric. All of these are valid criticisms, but as we've shown, all the relative valuation metrics tell the same story. And for those who shy away from choosing a metric because they all have blemishes, don't forget that "in the valley of the blind, the one-eyed man is king,"6 even if everyone around him is skeptical.
Our answer to the question "Are stocks overvalued?" in the U.S. market is a resounding "Yes!" Our forecast for core U.S. equities is a 0.8% annualized real return over the next decade. The 10-year expected real return for emerging markets equity, however, is much higher at 5.9% a year. The return potential of the nondeveloped markets is so high, in fact, that the valuation models, warts and all, paint a very clear picture.
For readers interested in more details, please visit our Asset Allocation site.
