Yesterday I heard a Wall Street guru on CNBC say “The S&P500 P/E is now 20, so the market is overvalued by historical standards”. I think this argument is misguided as market valuation, in my opinion, is not an absolute. Rather, equities valuation should be a relative exercise which may or may not make sense based on the opportunity cost of an investment in the S&P500 at any given level.
My hypothesis is that one cannot say for certainty whether a P/E of 15, 20, or 25 indicates an overvaluation in the market without considering what the expected return on alternative investment options are. For example, a P/E of 20, which implies an earnings yield of 5%, may be attractive if all other investment alternatives yield less than 5%. Therefore, there must be a historical convergence between the prices investors are willing to pay for equities and other alternative investments such that the ratio between the equity yield of the S&P500 and the alternative investment of choice is 1. This I call the “Market Valuation Parity”.
Consider, for instance, the historical yield of the 10Y treasuries, which is near 7%. This is exactly what the earnings yield of the S&P500 historical P/E of 15 would imply. Therefore, it may not be a coincidence that the average P/E ratio for equities seems to be around 15. Whether by coincidence or not, the historical average of the ratio between S&P500 earnings yield and the yield offered by 10Y treasuries is 1. Therefore, it seems to me that this ratio could be a better indication of whether equities are an attractive asset class. Although we have chosen the 10Y treasuries, it would make sense to perform the exercise with other asset classes with similar liquidity. But for now, the chart of the ratio between S&P500 earning yield and the 10 year treasuries is shown below:
When the parity is less than 1, it is said that equities is the better option, or has an “attractive valuation”. As the chart shows, March of 2009 was the most attractive time for equities since 1974. Additionally, the parity indicates that although the market is trading at a P/E of 20, it is still attractive based on what other investment options (in this case the 10Y treasury) offer at the moment. The chart also shows the excess that characterized the late 90s, when the parity reached 2.5 just before the collapse of the internet bubble.
A clear flaw is that the chart does not indicate any over-valuation before the 2008 crash, although it may also be indicative of artificially high earnings in the P/E ratio. Furthermore, the relationship that as long as the Federal Reserve keep rates low, the market earnings yield will be above the historical mean of 15. However, that does not automatically mean that the market is overvalued, as it may still offer a more attractive return than other investment alternatives.
The same exercise could be done using the average 10-year earnings yield (courtesy of Matt DeLano), as shown below: