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Reasons for caution about U.S. equity valuations

Qian Wang
Chief Economist, Asia-Pacific, and Global Head of the Vanguard Capital Markets Model

Higher interest rates can be a headwind for asset prices. The U.S. bond market has adjusted to them, as reflected in bonds’ sharp price drops over the past two years. The equity market, on the other hand, has continued to hit fresh highs, suggesting investors may be too complacent about expanding valuations.

Where valuations stand today 

Valuations—the market’s view on how much companies are worth—are looking a bit frothy. The chart below shows a common metric for valuing the U.S. equity market—the cyclically adjusted price/earnings (CAPE) ratio. To smooth out the impact of economic cycles, it considers current share prices in the context of 10-year inflation-adjusted earnings per share. In January 2024, the CAPE ratio for U.S. equities was over 30, higher than in most periods of the last 70 years. 

But what we think of as fair value for stocks depends in part on the macroeconomic environment, including interest rates, inflation, and market volatility. Higher stock market valuations can be justified during periods of low interest rates, low inflation, and low volatility. The low rates push down the discount rate and the cost of a stake today in a company’s future earnings.

U.S. equity prices have climbed to new highs even as the transition to a higher-interest-rate environment has depressed our estimate of where fair value lies. The widening gap between equity prices and our assessment leaves the U.S. equity valuation about 30% above our estimated range of its fair value. 

For context, U.S. stock valuations have rarely been this high. Their valuation today is at the 99th percentile, a level paralleled since 1950 only by the dot-com bubble and the post-COVID reopening.

How the valuation gap could close over time

A fall in interest rates could help close the valuation gap. Although we expect policy interest rate cuts this year, we don’t expect them to be enough to significantly increase our fair-value estimates. Beyond 2024, the fair-value range is unlikely to revert to levels that prevailed at the start of the decade. The era of near-zero interest rates is behind us.

It’s much more likely that the gap would close through falling equity prices.

The risk of a correction in equity prices has risen as valuations have become more stretched

Notes: Vanguard’s U.S. fair-value CAPE is based on a statistical model that adjusts CAPE measures for the level of inflation and interest rates. The statistical model specification is a three-variable vector error correction that includes equity-earnings yields, 10-year trailing inflation, and 10-year U.S. Treasury yields estimated from January 1940 through January 2024. Details were published in the 2017 Vanguard research paper Global Macro Matters: As U.S. Stock Prices Rise, the Risk-Return Trade-off Gets Tricky. A declining fair-value CAPE suggests that higher equity-risk premium (ERP) compensation is required, whereas a rising fair-value CAPE suggests that the ERP is compressing.

Sources: Vanguard calculations, based on data from Robert Shiller’s website, at aida.wss.yale.edu/~shiller/data.htm, the U.S. Bureau of Labor Statistics, the Federal Reserve Board, Refinitiv, and Global Financial Data.

What valuations can and can’t tell us

Valuations are a strong indicator of long-term equity returns. And that doesn’t bode well for the U.S. equity market given where valuations currently sit.

I’d caution, however, that while valuations are undoubtedly high right now, that doesn’t mean they can’t go higher in the near term. They are not a market-timing tool. And even over extended periods, valuations are not infallible predictors of outperformance or underperformance. 

That’s why, even with our more guarded outlook for U.S. equity returns over the next decade, we would not encourage investors to make drastic changes to their asset allocation.

Diversification is the healthy option 

Regardless of the return outlook for U.S. stocks, having a mix of assets that are not perfectly correlated helps reduce risk in a portfolio. Just as living a balanced life is conducive to good health, finding balance in an investment portfolio gives investors a healthy chance of achieving their long-term financial goals.

 

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.

Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets. 

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