Over time, the cost of liquidity, in the form of bid/offer spreads, has decreased. There are several reasons for this, including the decimalization of stock prices and the additional liquidity provided by high-frequency traders. Furthermore, the cost of commissions has collapsed. Other implementation costs, in the form of index mutual funds and ETFs’ much lower expense ratios, also have fallen, meaning investors are capturing more of the gross return to stocks, justifying higher valuations.
Summarizing, 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 forecast lower future returns, they aren’t necessarily signaling overvaluation.
With the 10-year TIPS (a benchmark for a riskless rate of return for a long-term investor) at about 0.6%, and a 3.8% expected real return to stocks, we have an equity risk premium (against that benchmark) of about 3.2%. No one knows if that is an appropriate return or not for the risk of equities. It’s just lower than the historical return. Thus, it seems hard to make the case that equities are overvalued.
Before closing, I would add that the outlook for returns for international equities is somewhat better than it is for U.S. stocks. At year-end 2017, the U.S. CAPE 10 earnings yield, which provides the real return forecast, was 3.1%. For developed non-U.S. markets, it was 5.1%, and for emerging markets it was 6.3%. All three figures are now lower given the very strong returns we have had to start the year.
The bottom line is that investors should not be using stock valuations to time the market. However, it is important for investors to take into account higher valuations (and lower bond yields) when they forecast future expected returns and build plans based on those forward-looking estimates. What rates of return are you assuming in your plan?
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.