Sky High Valuations Could Spell Weaker Forward Returns

December 8, 2021 |
2 minute read
|

When we look for potential roadblocks that could spoil the breakneck pace of capital markets, the first risk that comes to mind is record-high valuations. While inflation risks have become more top-of-mind recently, price multiples have been trending above historical averages during the last six years, except for a few brief periods of market correction. The U.S. is by far the most overvalued region with price-to-earnings and price-to-sales ratios 1.5 and 2 standard deviations above their mean values, helped by strong growth, capital inflows, supportive Fed policy and high allocations to expensive technology and consumer discretionary stocks. 

The Buffett indicator, the ratio of total market capitalization to nominal GDP, is another approach to measuring market valuation popularized by the famed Investor, Warren Buffet. The current estimate of the total U.S. market capitalization using the Wilshire 5000 index is around $52 trillion. Prior to 1970, the changes in the Financial Account - Nonfinancial corporate business; corporate equities; liability, Level were used to calculate the U.S. total market capitalization and complete the data series back to 1950. The ratio of the total market capitalization and the nominal GDP of $23.6 trillion yields a current Buffett indicator reading of 2.21, a record high since 1950. While no valuation indicator has been perfect at predicting future market performance, high levels in the ratio have been linked to lower returns in the following 5-year periods, specifically during the late 1960s, 1990s and mid-2000s.   

Perhaps one of the biggest criticisms of the Buffett indicator and other price multiples such as the cyclically adjusted price-to-earnings (CAPE) ratio is that they fail to account for the level of interest rates. Investors decide on constructing portfolios around equities, bonds, hedge funds and real assets based on their investment return objectives and the relative return and risk properties of the asset classes. The steady decline in interest rates has produced strong gains for Treasuries over the past 30 years while eroding their future ability to diversify portfolios during risk-off periods. During the 1960s, 1990s and mid-2000s, investors had the option to allocate away from expensive equities to bonds with attractive yields. Today, allocations into Treasuries are expected to generate losses for investors after inflation, forcing them to seek yield and return in riskier assets. As a result, while markets are overvalued relative to their histories, they are fairly-valued relative to bond yields and are less likely to collapse as they did in 2000.     

At Commonfund, we review close to 40 different indicators which inform us on the current economic environment as well as the attractiveness of risky vs. defensive assets. One of the indicators we follow closely is the equity risk premium which measures the earnings yield of regional stocks markets vs. Treasury and corporate bonds yields. And, while the U.S. remains the least attractive market from a valuation perspective, equities remain attractive relative to fixed income providing at least some support going forward. 

 CH-SkyHighValuations

 

Ivo C. Nenin

Author

Ivo C. Nenin

Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

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Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.