Valuation of the stock market based on CAPE (also called Shiller PE)
I have been thinking for more than 1 year that the stock market is over-valued. Main reason why I reached this conclusion : I used the concept of cyclically adjusted PE (or Cape). Rather than calculating the PE based on 1 year earning, it calculates the PE based on the past 10 year earnings (inflation adjusted), so it better reflects the earnings on 1 cycle.
Based on this concept, S&P 500 has now a PE of 35 x, vs a median of around 16 x on long period. Such a difference can not be explained by interest rates as 10 year treasury rate is now 4.22 % (vs a median of 3.81 % on long period).
So, it is interesting to try to understand why the CAPE ratio has been so poor to explain the performance of the market (during the last year).
There are probably several possible explanations : - the stock market valuation probably does not reflect today's interest rates, but the future interest rates, while there are clear expectations that interest rates should decline in the near future, - another possible explanation is that, unlike the past, S&P 500 depends more on more on tech companies, which have more stable earnings and more growth potential than past traditional companies, which could explain a higher stock market valuation. - the recent market rebound (in particular for Nasdaq companies) can also be explained by future expectations for AI (not discounted in the Shiller ratio, based on past earnings).
Overall, I still think that the best way to look at market's valuation is to look at the equity risk premium. Historically, based on Shiller data, I estimate that the median risk premium was around 2.5 %. It is now - 1.4 % based on the same data (looking at earning yield - 10 year treasury rate yield). So, the discussion is probably about what is the appropriate risk premium ? based on what future 10 year treasury rate ?
I have no obvious answer, but think that equity risk premium could be lower than in the past (as there is less volatility with tech earnings), but can't find any reason why equity risk premium should be negative. The answer also depends on the expected level of future interest rates, which I find very difficult to predict.
