Tuesday, May 10, 2011
One very long-running theme on this blog has been that equities are not overpriced, overvalued, or otherwise in a valuation bubble. Here's another chart that supports that theme, and even suggests equities could be undervalued.
To appreciate the chart, you need to understand and agree with a few assumptions. For one, the S&P 500 index is a good proxy for the value of all corporate equities. Two, equity prices can be thought of as the discounted present value of future after-tax profits. Three, the 10-yr Treasury yield is a reasonable interest rate to use when discounting future cash flows. Four, nominal GDP is a good proxy for corporate cash flows. The blue line in the chart represents the value of equities as a % of nominal GDP, and the red line is the yield on 10-yr Treasuries.
The basic implication of the assumptions is that the ratio of corporate equities to nominal GDP should vary inversely with interest rates. If interest rates rise, then equity values should decline relative to nominal GDP (since they are being discounted at a higher rate), and vice versa. If interest rates are relatively stable, then the ratio of equity prices to nominal GDP should be relatively stable over time.
Looking at the chart, it's clear that equity values relative to GDP did indeed decline from the 1960s through the early 1980s as interest rates rose. Subsequently, equity valuations rose as interest rates fell. Equity valuations way overshot in the late 1990s and early 2000s, and we now know that was indeed a "bubble." Since then, equity valuations appear to have undershot; interest rates today are about where they were in the 1960s, but equity valuations today are about 25% below the levels of the 1960s.
A reasonable person could argue that interest rates likely are being artificially depressed these days by Fed policy, and that the market is wise to this and therefore is using a higher interest rate than the 10-yr Treasury yield to discount future cash flows. Yet even if that were true, and the market were implicitly assuming, say, a 7% discount rate, it would still be the case that equities are not overvalued at current levels, using this model.
Posted by Scott Grannis at 2:02 PM