Interesting to look at the US market valuation, while the consensus is now turning really bearish.
My favourite tool to look at market valuation remains CAPE* (Cyclically Adjusted PE), as it takes into account all the elements which look important : average earnings on a long period**, risk premium and the 10 year US treasury yield.
Today, CAPE is at 34.5 x which corresponds to an earning yield of 2.9 %.
Obviously, this PE is really high as it corresponds to a negative risk premium (10 year treasury yield is 4.27 % now).
This level of CAPE is also really high when we compare it to the median CAPE on a long period, which was 16 x (or an earning yield of 6.2 % = 1/16).
This median PE was reached together with a median 10 year yield of 3.82 % on long period.
As a result, we can estimate that, on a long period, the equity risk premium was 2.38 % = 6.2 % -3.82 $.
So to estimate the future market value, I think that we need to take into account 3 elements : long term earnings, US 10 year yield and risk premium.
1/ Scenario where Cape comes back to the median level
I estimate that average earnings*** and risk premium should be stable on a long period, so the main adjustment should come from US 10 year yield.
Looking at today's long term earnings, using a normalised risk premium of 2.38 % and the 10 year treasury on a long period of of 3.82 %, Cape should be 16.1 x vs 34.5 x now.
So it corresponds to a potential decrease of 53 % for S&P 500.
Interesting also to note that the market has come back to this level of Cape just once since 1990.
It was during the crisis of 2008-2009, when the CAPE bottomed at 14.1 in Feb 09.
2/ Most optimistic scenario
The most optimistic scenario is probably to use the case we saw in July 2020 (covid crisis) when 10 year treasury rate decreased to 0.62 %.
In that case, if we still use the normalised level of risk premium of 2.38 %, the expected earning yield could be 3 % (= 0.62 % +2.38 %) or a CAPE of 33.3 x. Very close to today's level of 34.5.
3/ So, what is the most likely scenario ?If we are optimistic about long term yield, it is clear that the potential of market decrease is now limited (after a decrease of around 10 % for S&P 500).
The main question now is about stagflation : if the market expects a stagflation scenario, long term yield can't come back to the 0.6 % level.
At the same time, it is interesting to note that long term yield has recently decreased in the US from 4.8 % to 4.27 %, so the market is ready to accept lower long term rates, despite talks of possible stagflation.
It is possible that markets are still too pessimistic about Trump policies impact on prices. The recent decrease of long term rates show that the market has begun to discount less future inflation from these policies.
* all the figures here are from Shiller PE website and look at S&P500 on a long period (before 1880 until today).
** average of inflation-adjusted earnings over the past 10 years
*** between Jan 19 and Sept 24, these long term earnings have increased by 20 % or about 3 % per year.
Expand
