August 3, 2010 Leave a comment
Are global stock markets spectacularly overvalued compared to their longer term trends?
One basic way to compare stock market valuations over time periods is to look at the market’s P/E ratio. This metric can be quite volatile due to short term variations in both price and earnings. A more stable metric is the ratio of price to earnings that are averaged over a few years. This post on SeekingAlpha does a nice job of analyzing P/E ratios calculated using trailing 10 year average earnings. The chart below is quite interesting:
The current market’s P/E ratio of 21.7 is significantly above the long term mean of about 15. So is the current market significantly overvalued?
Look carefully at the period after 1980 on the bottom chart. It appears that over the last 30 years, the market has systematically risen above its long term mean P/E ratios, and has stayed there – in spite of the two mega crashes of 2001 and 2008! Why should that be the case?
When looking at market valuations and P/E ratios over such a long term, a few other things come into the picture. Here are at least three reasons which could lead to secular changes in ‘normal’ P/E for the market:
1) Sustained period of strong growth expectation. This is the obvious one. However, it’s unlikely that the US market is factoring this in at the current point.
2) Risk free interest rate. The lower the interest rates are, the lower the denominator (discount rate) that the market factors into the valuation of each component, hence leading to higher overall P/E. Future interest rate expectation is disproportionately impacted by current interest rates, so the market would typically have a higher P/E when interest rates are very low – like now. Interest rates in the Western world have consistently fallen over the last 30 years. This coincides with the trend of higher P/E ratios over the same period.
3) The third confounding factor is the overall demand/supply for equities in the market. It would be interesting to see how the evolution of market P/Es correlate with wider equity/mutual fund ownership among the general population. Empirically, the advent of the ‘information age’ has made it much easier for small retail investors to own equities and mutual funds. Additionally, in the US, government-driven focus on 401K (retirement savings) plans has also increased equity market participation. Both of these trends have significantly driven up overall demand for equities. Such a sustained increase in general demand would also lead to higher market P/E ratios over the long term.
I think the above factors could have led to a long-lasting shift in the market’s “normal” P/E ratio. Wonder if there is a good way to assess market valuations in light of these additional factors?