Why U.S. stock market valuations are very high

The U.S. stock market’s valuation in 2017 is pretty high compared to the long run historical average. However, the “long run” historical average has changed over time. For example, the average valuation from 1990-present is much higher than the average valuation from 1950-1990. That’s why high valuations don’t guarantee weak future returns. The definition of “high” changes over time.
Here are a few valuation indicators.
Here’s the Shiller P/E 10.

Here’s the ratio of the stock market’s total market cap to U.S. GDP

Here’s the S&P’s trailing 12 month P/E ratio.

There’s a simple reason why long run valuations today are much higher than they were before. Interest rates are much lower.
Various asset classes are substitutes for each other. Yield-generating asset ABC is “cheap/expensive” RELATIVE to yield-generating asset XYZ. The two most common substitutes are stocks and bonds.
E.g. When bond yields go up, the S&P 500’s earnings yield needs to go up in order to maintain a same level of “attractiveness” to investors.
This is why dividend investing has become very popular since 2009. With interest rates at all time lows, investors are yield-starved. They have no choice but to buy stocks.
In the following charts, you’ll see that the stock market is still “cheap” relative to bond yields. We calculated the difference between the S&P 500’s earnings yield and various Treasury bond yields.

Difference between the S&P 500’s earnings yield and the 10 year Treasury yield

As you can see, “the S&P’s earnings yield – 10 year Treasury yield” was this high in the late-1970s and late-1960s. In both of those cases, the S&P rallied for a few more years. This is another similarity between today and 1966-1968.
Our medium-long term model states that the current bull market in stocks has 2-3 years left. Over the next 2 years, interest rates will rise (especially short term rates) while the S&P’s earnings yield will be relatively flat. Hence, the difference between earnings yield & Treasury yield will continue to decline.

Difference between the S&P 500’s earnings yield and the 5 year Treasury yield

As you can see, the “earnings yield – 5 year Treasury yield” paints a similar story to “earnings yield – 10 year Treasury yield”.

Bottom line

You can’t use this indicator to predict bull market tops. But it does help explain why valuations are “high”.
​*Whether you think “the evil Fed” is keeping rates artificially low is up to you. We see central banks as a force for good. Without the Fed, 2008 could easily have turned into a 1929 Great Depression. There were too many similarities – a financial system collapse in which fear became self-fulfilling.

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