Might low interest rates justify what otherwise appears to be extreme overvaluation in the stock market?
I’ve argued on previous occasions that they do not. But a new study has led me to at least partially reconsider my position.
The reason for my earlier skepticism was the faulty reasoning used by many who compare the Treasury’s 10-year yield TMUBMUSD10Y, 1.968% to the stock market’s earnings yield (the inverse of the price-to-earnings ratio). This lies at the heart of the so-called Fed Model, and as Cliff Asness, founder of AQR Capital Management, famously pointed out 20 years ago in an article titled “Fight the Fed Model,” it erroneously compares a real number (the earnings yield) with a nominal number.
Economists refer to the confusion this causes as “money illusion” or “inflation illusion.” Any conclusions the Fed Model produces about the stock market’s valuation are therefore theoretically suspect.
But what if, instead of comparing the stock market’s earnings yield to a nominal interest rate, we compare it to a real interest rate — specifically, the yield on Treasury Inflation-Protected Securities (TIPS)?
While that is not a new insight, this new study operationalizes it into a specific market-timing model in which our equity exposure level is proportional to the spread between the earnings yield and the TIPS yield.
Titled “Man Doth Not Invest by Earnings Yield Alone,” it was written by James White and Victor Haghani of Elm Partners, a money-management firm. The model they devised significantly beat a buy-and-hold strategy over the last couple of decades.
To illustrate how this model works, the authors focus on the cyclically adjusted price/earnings ratio, known as the CAPE. It currently stands at 37.79 (see table below). The only other time since 1881 in which the CAPE was any higher was at the top of the internet bubble. If we ended our analysis at this point, we’d have to conclude that the stock market is as vulnerable to a bubble bursting, as it did in 2000. But that overlooks the much higher TIPS yield that existed in 2000 than today. Surely this is relevant, they argue:
“Consider that the earnings yield of the U.S. stock market was about 2.7% at the end of 2000 and also at the end of 2021 — but the 10-year TIPS yield was 3.6% back in 2000 and minus 0.7% at the end of 2021. Would a rational investor choosing between equities and TIPS want to have the same exposure to equities at both points in time, just because the earnings yield was the same? We think most investors would agree that they should want to own more equities at the end of 2021 than 21 years earlier. And yet, the conventional analysis that uses the market’s earnings yield without reference to the real return offered by safe assets suggests owning the same amount of equities in both cases.”
What does this mean for today? Though the CAPE’s current earnings yield is low in an absolute sense, it is high relative to the negative real yield from TIPS. According to the model the authors devise, at the end of 2021 you would have wanted to have about 50% of your stock-bond portfolio invested in stocks. If their model had existed in 2000, in contrast, it would have recommended a 0% equity allocation.
So maybe, just maybe, the stock market isn’t as overvalued as the conventional valuation indicators have been suggesting.
Unfortunately, this new insight must remain somewhat tentative, since TIPS have only existed since the late 1990s. So there’s no way of knowing whether comparing the earnings yield to the TIPS yield would have been a good idea for the century prior. More research is definitely in order, however, and I will report any findings in this space in coming months.
Current status of valuation indicators
In the meantime, the table below reports the latest values of the eight indicators I report each month in this space. These are the eight that, according to my research, have the best long-term records predicting the stock market’s 10-year returns.
Notice that, along with the stock market’s recent weakness, these indicators are indicating that the stock market is somewhat less overvalued than it was a few months ago. The P/E ratio is now lower than more than half the P/E ratios since 2000, as indicated by its percentile rank in the table dropping to 48.
| Latest | Month ago | Beginning of year | Percentile since 2000 (100 most bearish) | Percentile since 1970 (100 most bearish) | Percentile since 1950 (100 most bearish) | |
| P/E ratio | 21.80 | 22.96 | 24.23 | 48% | 68% | 76% |
| CAPE ratio | 37.79 | 37.73 | 38.66 | 98% | 95% | 97% |
| P/Dividend ratio | 1.41% | 1.30% | 1.30% | 91% | 92% | 94% |
| P/sales ratio | 2.84 | 2.99 | 3.15 | 87% | 87% | 87% |
| P/book ratio | 4.36 | 4.59 | 4.85 | 88% | 85% | 85% |
| Q ratio | 2.04 | 2.15 | 2.27 | 89% | 94% | 96% |
| Buffett ratio (Market cap/GDP ) | 1.82 | 1.92 | 2.03 | 93% | 97% | 97% |
| Average household equity allocation | 50.5% | 50.5% | 50.5% | 99% | 98% | 99% |
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
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