We’ve been hearing for quite some time now that US market valuation levels are quite elevated. As a matter of fact, the CAPE ratio has only been higher in 1929 and 2000, according to Robert Shiller’s publicly available data.
Comparing valuation multiples across different cycles can provide valuable context in an absolute sense but doesn’t necessarily tell the whole story.
Comparing earnings yields to interest rates, while flawed in certain ways, can provide more insight into cyclical valuation levels from one cycle to the next.
The spread between Professor Shiller’s cyclically adjusted earnings yield (1/CAPE) and the nominal 10-year US Treasury yield is higher today than it was in early-1990, early-2000 and mid-2007, potentially implying the market is not as overvalued today, relative to bonds, as it was on the eves of the three most recent recessions.
When we compare the cyclically adjusted earnings yield to the real 10-year US Treasury yield, we again find that today’s spread is higher than the three aforementioned periods although as observed in the chart below, the difference between today and the previous periods is not as pronounced. Again, a potential takeaway from this analysis is that the market is not as overvalued today, relative to bonds, as it was on the eves of the three most recent U.S. recessions.
Whether you’re a believer or a non-believer in the Fed Model, it does provide a simplistic way of comparing investment opportunity costs across cycles, which can, at a minimum, provide valuable insight. Additionally, interest rates and their related expectations do in fact drive asset valuations. It would appear today the market doesn’t think interest rates are going up enough to materially impact asset valuations any time soon. On that note, it probably makes a lot of sense to get as good of a grip as possible on where interest rates are going and how quickly they are going to get there.
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