Additionally, the cost of commissions has collapsed. Furthermore, other implementation costs—in the form of much lower expense ratios of index mutual funds and ETFs—have fallen, meaning investors are capturing more of the gross return to stocks, justifying higher valuations.
Again, the important point to remember is that if higher valuations are justified by systematic changes that make equity investing less risky/less costly, while they may be forecasting lower future returns, they aren’t necessarily signaling overvaluation.
Once we account for these issues, and the appropriate adjustments are considered, there’s a case to be made that the U.S. stock market no longer looks so overvalued. Perhaps it doesn’t look overvalued at all.
There’s further good news for investors who don’t suffer from home country bias: Internationally, valuations are much lower and, thus, forward-looking return expectations are higher.
For example, while the forward-looking P/E in the U.S. currently is 17.6, the equivalent figure for the MSCI All Country World ex-US Index is just 14.1, below its 20-year average of 14.7, and the dividend yield is 3.2%, below its 20-year average of 2.9%. While, domestically, the CAPE 10 is about 30, based on data provided by AQR, at the end of June 2017, it was 18.5 in non-U.S. developed markets and 14.3 in emerging markets.
We have just one more point to cover. While the research, such as Clifford Asness’ November 2012 paper, “An Old Friend: The Stock Market’s Shiller PE,” has shown that 10-year forward average real returns fall nearly monotonically as starting CAPE 10 P/E ratios increase, and as the starting Shiller CAPE 10 increases, worst cases get worse and best cases get weaker (the entire distribution of returns shifted to the left), there were still very wide dispersions of returns.
For example, even when the CAPE 10 P/E ratio was above 25, the best 10-year real return was 6.3%, less than 1 percentage point below the historical average. Such wide dispersions explain why the Shiller CAPE 10, while providing information on future returns, should not be used as a tool to time the markets.