Measuring equity valuation

Our experts discuss why traditional price/earnings ratios aren’t an accurate barometer of stock market valuations.

TRANSCRIPT

Global macro matters

Lara DeLaIglesia

Lara de la Iglesia: The stock market can be volatile, right? We all know that. You trade risks for the prospects of higher returns. But those risks have really been on display recently, so I have to ask, given that, what’s our outlook for the global stock market right now?

Roger Aliaga-Díaz: Yeah, our outlook over the next ten years, let’s say, is easily subdued compared to historical averages. It’s in the order of 4.5 to 6.5% over the next ten years for the global market, perhaps a little bit lower than that for the U.S. equity market in particular.

And it’s important to remind investors although periods of high volatility that we went through naturally raise some questions about the prospects of the market, here the idea is more to think about the long term, basically what the equity markets can do for your portfolio over the medium and long term. So the idea is not really to make a market call. It’s much more about trying to recalibrate expectations, basically give a more realistic assessment of what investors can expect in their portfolio so they can make better decisions, strategic decisions related to saving or basically what are the odds of successfully achieving their investment goals.

Lara de la Iglesia: So, Harsh, your team manages a tool that Vanguard uses to look at equity market valuations. Tell me a bit about that.

Harshdeep Aluwalia
Harshdeep Aluwalia

Harshdeep Ahluwalia: Sure. Our view of whether the equity market is overvalued or undervalued is based on a valuation metric called the CAPE, or the cyclically adjusted P/E ratio, price-to-earnings ratio.

Lara de la Iglesia: Okay.

Harshdeep Ahluwalia: A more traditional valuation metric or price-to-earnings ratio uses a 12-month trailing average for earnings. Now the cyclically adjusted P/E ratio uses a 10-year average inflation-adjusted earnings metric.

Lara de la Iglesia: Okay.

Harshdeep Ahluwalia: And we can use this metric to determine if the equity market is over or undervalued. At the current time, the CAPE is above its long-term historical average, and this can cause some investors to conclude that the U.S. equity market is extremely overvalued, like it would be in a bubble.

Lara de la Iglesia: Okay.

Roger Aliaga-Diaz
Roger Aliaga-Diaz

Roger Aliaga-Díaz: Well here it’s important to point out that, to Harsh’s point, many investors or analysts compare these ratios like the price/earning and the CAPE, to historical average. So one thing that’s important to keep in mind is also what is the market environment and the economic environment in which you’re looking at the market.

For example, because of very low interest rates and very low inflation, such as the current period, it leads naturally to levels of valuation that are higher. And in that sense, one needs to adjust a little bit this comparison. Sometimes comparing to the historical average could be a little bit misleading.

Lara de la Iglesia: Okay, so Vanguard’s developed a more comprehensive way of doing this, and I want to ask about that. Harsh, we’ve recently published some research on that in The Journal of Portfolio Management. Can you share with me what does Vanguard’s method include?

Harshdeep Ahluwalia: Sure. Here at Vanguard we’ve developed a metric called a “fair-value” CAPE, which essentially adjusts the CAPE for the current levels of inflation and interest rates.

Lara de la Iglesia: Okay.

Harshdeep Ahluwalia: So this fair-value CAPE provides a better benchmark for comparison against the CAPE, unlike the historical average.

So at present, the CAPE is slightly above our fair-value CAPE, but this kind of points us to the fact that the market is overvalued, but it’s not extremely overvalued.

Lara de la Iglesia: An important point for our investors to remember.

Roger Aliaga-Díaz: Right, so little return but not as strongly negative as you may infer from just looking at historical averages.

Lara de la Iglesia: Yes, all right, thank you.

Roger Aliaga-Díaz: Thank you.

Important information

All investing is subject to risk, including possible loss of principal.

IMPORTANT: The projections or other information generated by Vanguard’s fair-value CAPE ratio regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

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