Thoughts on U.S. Market Valuations

Dividend Payout Ratio

At the Chartered Financial Analyst (CFA) Institute Annual Conference in Philadelphia last month, there were a number of conversations with dour outlooks for the future of U.S. equity markets. The center stage of the conference featured a debate between Yale Professor Robert Shiller, designer of the CAPE (cyclically adjust price-to-earnings) ratio, versus my mentor, Professor Jeremy Siegel.

Shiller has a more subdued outlook for future returns than Siegel, who is a bit more optimistic. Jack Bogle also presented at the conference and suggested we’ve seen strong gains in the markets over the last 35 years that resulted from valuation expansion, and hence also had a more subdued outlook. Bogle’s model was fairly simple: take the 2% dividend yield on the market today, add in his personal estimates of 4% earnings growth, and subtract 2% from speculative market activity or his anticipation of a decline in valuation ratios over the coming decade, and you come up with an outlook for 4% returns over the coming decade. If we assume there is 2% inflation, this would lead to just a 2% real return after inflation. Note that this is largely similar to Shiller’s outlook for returns.

One chart that I think is not talked about enough in the context of valuation changes on the market is the dividend payout ratio of the market. I show a smoothed 10-year average dividend payout ratio in the spirit of Shiller’s 10-year smoothed earnings for the CAPE ratio. Prior to 2000, the dividend payout ratio averaged 60%. Since 2000, the dividend payout ratio has averaged 40%. This change in the nature of how firms reinvest their earnings, conduct stock buybacks, and pay dividends is absolutely critical to the future earnings growth we are likely to get.

CAPE EPS Growth Rate

Those who assume that earnings growth rates will revert to some historical average growth rate when firms paid out 60% of their earnings as dividends are assuming that all this money not being paid out—used for either buybacks or other reinvestment in business—is being completely wasted. That is an incorrect assumption, in my view.

This chart looks at the rolling 10-year and 20-year earnings growth rates of the CAPE earnings per share (EPS) that Bob Shiller uses to make his dour forecasts on the market. If these numbers were to “mean revert,” that would be a cautionary tale for the markets. But in my view, the earlier declining dividend payout ratio means we are likely to see upside changes to these earnings figures. What is possible?

Changing dividend payout ratios have already translated to better earnings growth. Prior to 1982, the average dividend yield on the U.S. equity market was approximately 5% per Shiller’s data, and we had an average dividend payout rate of nearly two-thirds of earnings paid out as dividends. With only a third of earnings reinvested, firms were still able to achieve earnings growth of 3.3% per year.

Shiller Data

Since 1982, payout ratios declined to an average of 51.1%, while at the same time firms started conducting stock buybacks. The average EPS growth during this period of reducing dividend payout ratios was an increase of 160 basis points (bps) per year, from the previous long-term average of 3.3% per year to 4.9% per year.

When we look at the last 20 years, and particularly the last seven, we see consistent signs of 2% dividend yields with 2% net buyback ratios. These net buybacks are going to continue to support earnings growth for the 10-year look-ahead period. These firms have locked in future EPS growth because they reduced their shares outstanding.

Returning to the table above, where I showed the earnings growth since 1982 as being higher than the previous 110 years, the current dividend payout ratios are consistent with an even further drop in the payout ratios from their average since 1982. I can see a case that earnings growth picks up even from that 4.9%-per-year mark that we had for the period 1982–2016. It would not surprise me to see earnings growth of 6% to 7% per year over the next decade.

Dividends Buybacks

The standard pushback is that firms are just leveraging up to conduct buybacks—that interest rates are at historical lows, leading to higher margins than are sustainable. The reverse case is that the changing composition of companies—into higher-margin businesses that have more revenue abroad with lower tax rates than in the U.S.—also means margins may not be mean reverting anytime soon either. Of course, no one knows how the future will unfold, including me.

The charts above caution anyone relying on historical patterns of earnings growth trends from overextrapolating them into the future. Professor Siegel looks at the current earnings yield of the market associated with a 20 price/earnings ratio and thinks 5% is a pretty good indicator of long-term, after-inflation real returns. Add in inflation of 2% and you get 7% nominal returns. This is a touch below their historical 6.5% to 7% that he showed in Stocks for the Long Run as being the historical return to U.S. equities, but it is not dramatically different. I think his model for looking at the markets makes more sense than some of these more dour predictions—for what that’s worth.

Jeremy Schwartz is the Director of Research at WisdomTree Investments.


Important Risks Related to this Article

Dividends are not guaranteed, and a company currently paying dividends may cease paying dividends at any time.

The Meaning of Lower Corporate Earnings

SP500 Earnings

Few things go up forever, and corporate earnings are no exception. Earnings season began this week as companies started reporting their performance for the start of 2015, and American companies’ earnings are expected to decline compared to the same period last year. Should you be worried that this decline heralds the end of the bull market in stocks that’s lasted since the end of the financial crisis?

The short answer is “not too much.” There’s always some variation in earnings from one quarter to the next, not only for individual companies but also for the stock market as a whole. Such variation even occurs during long periods of stock market gains (such as the current one): there were a couple quarters in 2012 where earnings declined, and US stocks proceeded to soar in 2013.

This quarter’s projected earnings dip may also be largely the result of transient factors. The recent rise in the value of the US dollar against foreign currencies has hurt American exporters by making their products more expensive overseas, and the plunge in the oil price has hurt energy companies. If these trends reverse, or if companies adjust their strategies to adapt to the stronger dollar and cheaper oil price, earnings could bounce back.

That being said, lower earnings aren’t completely benign. Most valuation metrics indicate that US stocks are slightly overvalued by historical standards, meaning that either earnings growth needs to accelerate or that future stock market returns will be lower than average. The earnings slowdown suggests that the second outcome may be more likely, and investors should reduce their expectations about the medium-term returns that they’re likely to get from US stocks.

How to Think Like a Long-Term Investor


For investors concerned about what will affect the long-term growth of their portfolio, it can be difficult to focus on the right issues. Most financial news stories are produced for traders and others in the financial industry who are interested in daily market movements. After all, their paychecks can depend on what goes up and what goes down. But for long-term investors, the implications of what’s happening can be very different. Here are a few interesting—and perhaps counter-intuitive—ideas for long-term investors to keep in mind amid the din of financial markets:

1) Low valuations can be good. It’s nice to have a bigger portfolio, so it feels good when the values of your investments go up. But if you’re building up your nest egg, you actually want prices to be cheap so your money goes farther. You’ll end up getting the best outcome if valuations are low during the “accumulation phase” of your life when you’re buying investments and high during the “spending” phase of your life when you’re selling investments.

2) Volatility isn’t necessarily bad. The up and down movements of financial markets can be gut-wrenching. But if you’re making periodic investments over time, such as putting a portion of each paycheck into a retirement account, there can sometimes be a bright side to volatility. Since your money buys more shares when the market is lower than when the market is higher, the ups and downs may result in a larger portfolio over time than if the market had been flat. This phenomenon is similar to the idea behind dollar-cost averaging.

3) Standard deviation may be the wrong measure of risk. The riskiness of investments (or even entire portfolios) is often described using “annualized standard deviations,” which are statistical measures that can be used to estimate the range of possible outcomes for a 1-year period. But even assuming that these estimates are accurate, using them to estimate potential outcomes over longer periods of time typically means assuming that what happens in one year doesn’t affect what happens in subsequent years. In the real world this assumption isn’t true, so these kinds of estimates may overstate or understate how much risk you’re actually taking.

The Importance of International Diversification

International diversification

With a seemingly constant drip of bad news from around the globe—military conflicts in Eastern Europe and the Middle East, the spread of Ebola, slowing economic growth in Western Europe and many emerging markets—it may feel that the US is the only safe place to invest your money. But not having enough exposure outside the US means not enough diversification, and that can actually mean higher risk and potentially lower returns over the long run.

The performance of international stocks is driven by some of the same factors that affect US stocks. An upturn or downturn in the global economy, for example, may have an impact on stocks from all countries. But there are plenty of other things that can affect stocks in some countries but not others, such as different valuations, different economic growth rates, different demographics, and different political environments.

These differences mean that international stocks often don’t move in lockstep with US stocks. US stocks substantially outperformed international stocks in 2013, for example, but actually underperformed in 2012 despite the economic woes of the euro zone. Having exposure to both the US and to international markets therefore can mean fewer large ups and downs for your entire portfolio.

Despite overseas wars and economic weakness abroad, the benefits of a globally diversified portfolio may become even more apparent in the coming years. As we’ve noted before, US stocks currently appear to be slightly overvalued by historical standards. This fact doesn’t necessarily mean that US stocks will do poorly, but it increases the chances that their future returns will be below average.

Valuations on international stocks, by contrast, appear to be more in line with historical norms. Strategists at Research Affiliates project that over the next 10 years, current valuations will reduce the returns on US stocks by an average of 1.5% per year. For international developed stocks they think this number will only be 0.6% per year, and for emerging market stocks they think current valuations will actually increase returns by an average of 0.4% per year. Not having enough international exposure, in other words, could mean more risk and less reward.

Are Stock Valuations Too High?

US stocks have continued to climb this year even after surging by more than 30% in 2013. Earlier this year we argued that US stocks appeared to be slightly overvalued, but other analysts argue that stocks are fairly valued. Which analysis is correct?

To answer that question it’s important to remember the basics of how valuations apply for long-term investors. When valuations for a specific asset class are above their long-term average, we can expect the future medium-term returns for that asset class to be below their average. The opposite is true when valuations are below their long-term average.

In their latest quarterly outlook, analysts at JP Morgan have presented the following charts seeming to show that US stocks are fairly valued:

Stock Valuation Charts

The problem with this analysis is that their “long-term average” is based on 25 years of data, a brief interval in the long history of financial markets. The average value for the Shiller P-E ratio, for example, has been 25.1 over the past 25 years, only slightly below the current value. But its true long-term average (using data since the 1880’s) has been only 16.5, suggesting that current valuations are higher than normal.

Of course, valuations don’t tend to have much of an impact in the short-term (technology stocks continued climbing in the late 1990’s long after valuations reached extreme levels, for example). And US stocks today appear to be only slightly overvalued, unlike the extreme overvaluation of, say, technology stocks in the late 1990’s or Japanese stocks in the late 1980’s). So while valuations suggest that the future returns for US stocks may be slightly lower than they otherwise would be, they don’t preclude the possibility of the current bull market continuing for a while.

Brazil’s Stock Market Struggles

Brazil Stock Returns

Emerging market stocks haven’t done particularly well in recent years, but Brazilian stocks have done especially poorly. From 2010 through 2013, Brazilian stocks substantially underperformed emerging markets as a whole in each calendar year. So far this year, however, Brazilian stocks have outpaced their emerging market peers. Does this reversal herald a comeback for Brazil’s stock market?

The struggles of Brazilian companies have a number of causes. The country has been battling persistently high inflation, currently above 6% per year. Worker productivity in Brazil has been weak due to factors such as poor infrastructure, a low-quality education system, and inefficient regulations. And declining commodity prices in recent years have hurt the country’s commodity producers.

Often times when a country’s stock market dramatically underperforms over a number of years, stock prices fall so far that they subsequently look cheap. By conventional valuation metrics such as price-to-earnings ratio and price-to-book ratio, however, the valuation of Brazil’s stocks isn’t much different from emerging markets overall. Other valuation measures, such as the ratio of the size of the country’s economy to the size of its stock market, suggest that Brazilian stocks may indeed be undervalued, but less so than other emerging markets such as China.

Since Brazilian valuations don’t seem especially attractive, the country’s stock market will likely need something else to provide a boost if it’s going to build on the gains achieved so far this year. Perhaps elections in October will provide the impetus for pro-growth economic reforms, or a stronger global economy will lead to higher commodity prices. If not, the stock market gains so far this year may be an aberration rather than the start of a trend.

What the P-E Ratio Is Saying

P-E Ratio Graph








With the S&P 500 index of large US stocks having risen by close to 150% since its trough during the financial crisis, are US stocks now overvalued? One way to answer this question is by looking at the price-to-earnings ratio (or “P-E ratio”), which measures how high stock prices are relative to the profits that companies are generating. If the P-E ratio for the market as a whole is higher than its historical average, investors may be overvaluing stocks and the future returns from investing in the stock market may be below average.

The P-E ratio for the S&P 500 is currently about 19.5, above its historical average of around 15.5, suggesting that stocks are slightly overvalued. But one problem with using P-E ratios is that companies’ earnings can bounce around a lot, making historical comparisons difficult. In hindsight stocks were clearly overvalued in the late 1990’s, when euphoria about the prospects for technology companies pushed the P-E ratio for the S&P 500 above 30. But the market’s P-E ratio also surged in early 2009 as companies’ profits collapsed during the financial crisis, and that coincided with the start of the current bull market.

One way to get around this problem is to use the average of companies’ profits over a number of years. Robert Shiller, a professor at Yale University and recent recipient of the Nobel Prize in Economics, popularized a calculation that averages earnings over a 10-year period. According to his calculations, this 10-year P-E ratio is currently above 25, substantially higher than the long-term average of around 16.5. This metric has its critics as well: some argue that it puts too much weight on periods of abnormally low profits, such as the financial crisis. Proponents retort that historically it’s been one of the most accurate ways to predict future stock market returns.

So are US stocks currently overvalued? According to either of these measures of the P-E ratio, the answer is yes.