Tuesday, May 10, 2011

Another reason stocks are not overpriced

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.


John said...

Great post, Scott. Another reason may be that many past investors who have left the equity markets have not returned. Despite pockets of wealth creation such as Apple and America Movil the past decade has not been kind to equity investors. Many different asset classes have taken turns as most popular but I don't recall equities being one of them. Despite rising earnings and cash flows P-E ratios for many large cap stocks have steadily declined over the past decade. The late Walter Wriston of Citibank said 'money goes where its wanted and stays where its well treated'. In the last ten years equity investors have generally not been treated well. It will take time for that to change...but I believe it will. If so, there is still great opportunity in today's equity markets.

Benjamin said...

Great post.

I think we are in the first inning of a long bull game.

For all the reasons Scott mentions, but also for this: The global economy was growing prior to the 2008 meltdown of US financial institutions.

Despite the meltdown, much of the world is moving to roughly free markets. Even Cuba is exploring options.

So the last 20 years were pretty darned good, then we had this terrible 2008-2010 hiccup, and now the next 20 years will be pretty darned good too--if anything, even better.

I do worry (as does Charles Munger) that certain computer-enhanced and leveraged trading and derivative practices could lead to another torpedo. A Long-Term Capital Management on steroids.

But that is a Black Swan (I hope).

12.7k on the DJIA already, and we are not yet out of May. 14k on the DJIA in 2011. Maybe, maybe.

Dr William J McKibbin said...

Stocks are cheap right now -- buy while you can...

Lori said...


Last ten years have not been kind to investors?

Sorry you've missed.

Russian stocks 2000 to 2007. Or oil stocks since 2001 until now. Shipping stocks 2005 - 2007. Utility stocks 2002 thru today. Tree farmers 2000 thru 2011.

As well as the rails, 2001 thru today.

Christian S. Herzeca, Esq. said...

nice post; i haven't seen all of these variables mapped out like this before. very thoughtful.

John said...


You are pointing to isolated sectors...I was referring to broader averages. But your point is taken.

John said...


You are pointing to isolated sectors...I was referring to broader averages. But your point is taken.

TradingStrategyLetter - Weekly Summary said...

What do these lines look like if government contributinos to GDP are reduced by 50%?

Scott Grannis said...

Well over half of government spending consists of transfer payments, and these are not counted in the GDP calculation.