US equities overvalued, finds Research Affiliates

Aug 6th, 2015 | By | Category: Equities

US stocks are overvalued by most metrics, according to a recent report from smart beta specialist Research Affiliates. Whilst this may come as worrying news for investors in US equity ETFs such as the $177 billion SPDR S&P 500 ETF (SPY) or the $12.6 billion iShares Russell 1000 ETF (IWB), this does not mean that they might not appreciate further.

Low returns expected for US ETFs

Relative and absolute valuation measures are indicating low returns for US equity ETFs over the coming decade.

The analysis looked at a series of absolute and relative valuation measures to ascertain expected future returns. While these valuation models are useful in estimating the long-term return of the market, Research Affiliates warns that they can’t tell us with any accuracy when market prices will be heading up or down.

“Simply knowing a market is overvalued tells us nothing about when it is expected to revert to reality,” noted the report.

For the patient long-term investor, the insight that valuation models give is worthy of attention, and right now these models are pointing to low real returns in many regions. This is particularly true for US equities where Research Affiliates forecasts a 0.8% annualized real return over the next decade. In comparison, emerging market equities are relatively cheap, with an expected annualised real return of 5.9% over the same period.

Valuation measures indicate a variety of expected future returns and while no measure can be relied upon in isolation, the aggregate provides a range of potential outcomes. Absolute valuation measures such as the average of dividend and earnings yields and dividend yield plus growth are pointing to expected returns of 3.7% and 3.5% respectively. That said, Research Affiliates qualifies these measures: “The two absolute valuation models work well when yields remain constant, but in the real world prices can vary wildly around slower-moving fundamentals, such as dividends and earnings. As a result, it is also important to pay attention to relative valuations.”

Relative valuation models compare current price multiples to steady-state levels such as historical averages. The four relative valuation measures studied: cyclically-adjusted price-to-earnings (CAPE), Market Cap to GDP, Tobin’s Q and Hussman’s PE, all show the US market to be overvalued.


Values greater than zero indicate that the market is overvalued, or expensive, and values less than zero indicate that the market is undervalued, or cheap. (Graphic © Research Affiliates)

One of the limitations of relative valuation models is that they fail to take account of the prevailing economic environment. To tackle this problem Research Affiliates takes the analysis a step further, putting the CAPE ratio in the context of interest rates and inflation. “When real rates are either low or high, we tend to see low levels of Shiller CAPE. At more moderate levels of real rates, such as between 2% and 5%, higher valuation levels are the norm”, the study notes. There is currently a higher equity price than might be expected in this low-rate environment. “In fact, prices would have to drop over 37% to reach CAPE levels typically experienced at such low interest rates. Historically, markets have experienced a 3% annual real return in the 10 years following the valuation and rate relationship (high CAPE and low real rate) that we are seeing now.”

With forecasted real returns so low in developed markets, it may be worth considering a higher allocation to emerging market equities. The ETF investor looking for emerging market exposure has a great deal of choice. For UK and Europe-based investors, broad exposure can be accessed through funds from most major ETF providers such as the Vanguard FTSE Emerging Markets UCITS ETF (VFEM LN) and the iShares MSCI Emerging Markets ETF (IEEM LN). Investors looking for a lower-risk product should investigate the Lyxor FTSE Emerging Minimum Variance UCITS ETF (MVAM LN). Those with a preference for funds with a value or income tilt could look at the PowerShares FTSE RAFI Emerging Markets ETF (PSRM LN) or the WisdomTree Emerging Markets Equity Income UCITS ETF (DEM LN). (Many of these ETFs maintain continental European listings).

Alternatively, investors wishing to maintain their core long-term US equity ETF holdings but temporarily hedge their exposure given the “toppy” valuations could consider a small allocation to short ETFs, such as the Boost S&P 500 3x Short Daily ETP (3USS). This product provides three times the daily inverse performance of the S&P 500.

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