How overvalued is the Stock Market?

Caveat: this analysis was conducted before the Russian invasion of Ukraine. 

You can find the complete analysis at the following two URLs:

Stock Overvaluation at Slideshare.net

Stock Overvaluation at SlidesFinder 

As a first cut, one looks at PE ratios and quickly infer that the Stock Market is much overvalued. 

Whether you look at a regular PE ratio or Shiller PE ratio (using 10 years of inflation adjusted earnings), PE ratios are pretty high right now.  But, on a stand alone basis a PE ratio does not tell you much if at all.  If the PE ratio of the S&P 500 is around 25, does it mean that stocks are expensive relative to bonds or other assets?  Does it mean that stocks are overvalued relative to the inflation rate or other economic indicators?  Frankly, you have no idea. 

To start our analysis, let's first look at whether stocks are overvalued or not relative to 10 Year Treasuries.  To render both investments comparable, we are going to flip the PE ratio upside down, and instead look at the EP ratio (Earnings/Price) that is commonly referred to as the Market Earnings Yield.  And, we are going to compare this Market EP with 10 Year Treasuries yield.  

As shown above, when we compare the S&P 500 earnings yield (EP) with 10 Year Treasuries yield (by dividing the former vs. the latter), we can observe that based on historical data the Stock Market appears relatively cheap or undervalued relative to 10 Year Treasuries yield. 

We can extend this analysis to all different types of bonds, and the result is the same.  Currently, stock are actually a lot cheaper than bonds. 

The table above shows on the first row that the EP multiple of 10 Year Treasury is currently 2.2.  It is much higher than the long term average of 1.3.  Also, the EP - 10 Year Treasury yield spread is 1.73%, which is 1.47% higher than the long term average of 0.27%.  Given that, stocks are currently a lot cheaper than 10 Year Treasuries.  And, the story is the same for 30 Year Treasuries, Moody's Baa corporate bonds, and S&P BB and B rated bonds.  Thus, despite the S&P 500 having a pretty high PE, stocks are actually really cheap relative to bonds.  But, does that mean that stocks are truly cheap or undervalued?  Or, that bonds are even more overvalued than stocks.  

The table below discloses that stocks and bonds are actually all rather extraordinarily expensive relative to the current inflation rate. 

Looking at the first column from the left, the S&P 500 Earnings Yield (EP) is - 3.65 percentage points lower than the inflation rate over the past 12 months.  And, that is - 3.64 standard deviation below the long term average for this spread that stands at + 2.17%.  Thus, from this standpoint the stock market is greatly overvalued.  Notice, that it is the same story for all the bonds.

One can reasonably argue that the stocks and bonds overvaluation is very much due to a one-off abrupt spike in inflation that should abate somewhat over the next year or so.    

In January 2022, inflation, measured as the 12 month change in CPI, jumped to 7.5%.  This was the highest inflation rate since the early 1980s.  

Next, let's look at a more stable measure of inflation.  It is also forward looking which makes it very relevant for the stock market.  That measure is the 10 Year Inflation Expectation derived by measuring the spread between regular 10 Year Treasuries and Inflation Indexed 10 Year Treasuries.  The current spread between the two is 2.45%, in line with long term average.  Now, let's look at the valuation of stocks and bonds relative to this inflation expectation measure. 

As shown, even using this more stable measure of inflation, stocks and bonds are still very much overvalued relative to inflation expectations. 

We can look at two linear regression models to explore in more detail how overvalued are stocks relative to inflation and inflation expectations. 

The linear regression on the left shows that given a current inflation rate of 7.5%, the estimated stock market EP is 9.0% vs. an actual figure of 3.83%.  For the mentioned reasons, we won't focus much on this model and this inflation measure.  Instead, we will focus more on the less volatile and more forward looking inflation expectation measure and the related model within the scatter plot on the right.  

The linear regression on the right shows that given a current 10 year inflation expectation of 2.45%, the estimated stock market EP is 5.33% vs. an actual figure of 3.83%.  Focusing on the 10 year inflation expectation measure, it would entail a potential market correction of: 3.83%/5.33% - 1 = - 28%.  Notice that this regression model is not that explanatory (R Square 0.27).  So, there is much uncertainty around this potential market correction estimate.  Nevertheless, the current EP of 3.83% is 1.4 standard error below the estimate of 5.33%, indicating that 92% of this regression model residuals are higher than for this current observation.  That is pretty far out on the left-tail.  

      

 

 

The relationship between interest rates and the stock market.

 Both the Futures markets and the Federal Reserve expect the Fed Funds rate to reach around 1.50% during the first half of 2023.  Given that, investors are concerned that the market is in for a serious correction.  

You can read my complete study of the relationship between rates and the stock market at: 

Stock Market Study at Slideshare.net 

Stock Market Study at SlidesFinder.com

Higher rates entail a higher discount rate of prospective earning streams, therefore reducing the net present value of a company's stock.  On the other hand, higher rates are also often associated with economic growth  resulting in faster earnings growth.  Thus, higher discount rate vs. potentially faster earnings growth are countervailing forces.  Consequently, the relationship between (rising) interest rates and the stock market may not be as one-sided as anticipated.  

Using quarterly data going back to 1954, visually, we can observe that the relationship between interest rates and the stock market is rather weak, approaching randomness.  Whether we focus on the Feds Fund rate (FF) or the 10 Year Treasury one, a quarterly change in such rate is not that informative regarding quarterly change in the S&P 500 level.  

The correlation between the change in the S&P 500 and change in FF is only negative - 0.19.  And, it is negative - 0.24 with the 10 Year Treasury rate.  Both translates into R Squares that are very close to Zero, indicating that rates explain very little of the S&P 500 behavior.  That is pretty much what the graphs above are conveying.  The regression line has a slope that is very flat.  The confidence interval of the data-points location along that line is pretty wide.  The red ellipse show an image of near randomness.  

Focusing on 4-quarter change in the FF rates vs. the S&P 500, we compiled the following table based on data going back to 1954.  And, we focused on various FF rate increase ranges that reflect the prospective ones we are facing over the next year. 

As shown on the table above, FF increase levels do not clearly differentiate between S&P 500 level changes over 4 quarters.  Based on investment theory and monetary policy, you would expect that the higher the rise in FF, the lower the rise in S&P 500 over the reviewed period.  But, the empirical data does not quite support these common assumptions.  

Next, I built an OLS regression that also factored the influence of economic growth (rgdp), inflation (CPI), and quantitative easing (qe).  All variables were fully detrended on a quarterly basis. 

The regression shows a conundrum often encountered in such econometrics models.  The independent variables are statistically significant.  This suggests you have a pretty good model.  But, not so fast ...  this model is actually pretty poor with an Adjusted R Square of only 0.19.  It also has a very high standard error that is nearly as high as the standard deviation of the dependent variable, the change in the S&P 500 level. 

 

The facet graph above shows how mediocre this econometrics model is.  The residuals (red) capture a lot more of the volatility and the trend of the S&P 500 changes (black), than the model estimates (green). 

Next, I developed a couple of Vector Autoregression (VAR) models, one with 1-lag, and the other with 3-lags.  These VAR models were pretty much disastrous.  Probably the most efficient way to demonstrate that is to show that the VAR models were hardly any better than simply using a Naive model that would use as a single estimate the S&P 500 average quarterly change, and take its standard deviation as the standard error of this Naive model estimates. 

As shown above, the standard error of the two VAR models is hardly any lower than the standard deviation of the S&P 500.  The OLS regression model is clearly better than the VAR models.  Yet, its performance in terms of true error reduction (- 10.2%) is nothing to write home about. 

Additionally, the VAR models generated Impulse Response Functions that went in the wrong direction.  See below within the VAR model with 3 lags, the change in the S&P 500 over 8 quarterly periods in response to an upward 1 percentage point shock in FF.  It is positive.  That's clearly the wrong direction (as far as both investment theory and monetary policy are concerned.  

All of the above suggests that interest rate rises are not that deterministic in anticipating stock market downturns.  That may be in part because prospective FF rises or declines are already priced in the stock market through the Futures market.  Going forward, the market may very well encounter rough waters (as of this writing it already has).  But, it is for many more reasons than interest rates and even overall monetary policy alone.

 

Will we soon live to a 100?

 We are talking here of life expectancy at birth.   And, it represents the average (or probably the median) number of years one can expect to live when born in a given year.  This estimate is based on the current relevant mortality rate for each age-year.  

We already have centenarians now.  As a % of the population, the proportion of centenarians is likely to increase somewhat due to continuing progress in health care.  However, health care improvement may be partly countered by deterioration in health trends (rising diabetes, obesity rate, and declining fitness levels). 

To advance that in the near future we may reach a life expectancy of 100 is incredibly more challenging and unlikely than having a rising minority of the population reaching 100.  Here is why... for each person who dies at a more regular age of 70, you need 3 who make it to 110.  For each one who dies at birth, you need 10 who make it to 110. 

How about 90?  For each who dies at 70, you either need 2 who make it to a 100, or 1 who makes it to 110.  

You can see how the average life expectancy arithmetic is very forbidding. 

You can see my research on the subject at Slideshare.net and SlidesFinder.  

Live to a 100 at Slideshare    

Live to a 100 at SlidesFinder  

The above is a 35 slides presentation that is very visual and reads quickly.  Nevertheless, let me go over the main highlights. 

I looked at the life expectancy of just a few countries with very long life expectancy plus China and the US. 

                                                                                                                                                                           I observed an amazing amount of convergence between numerous countries that are geographically and genetically very distant.  These countries have also very different culture, lifestyle, and nutrition.  Yet, they all fare very well and have a converging life expectancy above 80 years old (several years higher than China and the US).  And, also several of those countries started from dramatically lower starting points.  This is especially true for Korea (South) that had a life expectancy much under 40 back in 1950.  And, now Korea's life expectancy is nearly as long as Japan, much above 80 years old

Next, I looked at the UN forecasts of such life expectancy out to 2099.  And, I found such forecasts incredibly optimistic. 

As shown, all countries' respective life expectancy keeps on rising in a linear fashion by 1.1 year per decade.  This seems highly unlikely.  The longer the life expectancy, the harder any further increase becomes.  The forecasts instead should probably be shaped as a logarithmic curve reflecting smaller improvements as life expectancy rises. 

I did attempt to generate forecasts for a few countries (Japan and the US) using linear-log regressions to follow the above shape, but without much success.  This was in part because the historical data from 1950 to 2020 is often pretty close to being linear ... just like the first half of the logarithmic curve above is also very close to being linear.  Maybe if I had modeled Korea, I may have had more success using a linear-log model.  But, there was no way I could have successfully used this model structure for all countries covered because the country-level historical data had often not yet entered its logarithmic faze (slower increase in life expectancy).  The UN forecasts entailed that if the history was linear, the forecasts would be linear too ... a rather questionable assumption.   

Also, as mentioned current deteriorations in health trends are not supportive of rising life expectancy...  especially life expectancy keeping on rising forever in a linear fashion.  I call this questionable forecasting method the danger of linear extrapolation. 

As shown below, the rate of diabetes is rising worldwide. 

Also, BMI is rising worldwide. 

This deterioration in health trends represents material headwinds against life expectancy keeping on rising into the distant future. 

The full presentation includes much more coverage on all the countries, more info on health trends; and it also looks at healthy life expectancy, a very interesting and maybe even more relevant subject than life expectancy.  Who wants to live to a 100 if it entails 30 years of disability.  Healthy life expectancy is what we really want.  At a high level, healthy life expectancy is typically a decade shorter than life expectancy.  For more detailed information go to the full presentations.