The Stock Market Looks Overvalued, but It's Probably Not
Jacob Hess
January 20, 2021
It's no secret that the stock market, at the surface, is exhibiting bubble-like features. Investors traded through the most troubling year since 2008 dealing with unprecedented events including the first global pandemic since the 1918 Spanish flu. Despite seemingly insurmountable obstacles, the value of the public companies in the United States rose and continue to rise at the beginning of 2021. It was a market reliant on expectations more than ever before driven by headlines that hope and relief were coming in stimulus, the reopening of businesses, and a vaccine. As the economy teeters on the fence between that hope and impending despair, investors search for ways to justify these bubble-like features that typically indicate bearishness.
Moody's Chief Capital Markets Economist John Lonski. points out that "the market value of common stock now approximates a record-high 185% of GDP" in a January 14th report comparing it to the peak of 137% of GDP during the 1999-2000 dot-com bubble in 2000 Q1. The last time it reached comparable heights was 140% in 2018 Q1. The stock market's value compared to corporate profits has elevated as well. At 18.4 to 1, its at its highest level since 2001 Q3 at 18.6 to 1. The growth in this ratio may also be attributed to the economic difficulties brought on by the COVID-19 pandemic.
While these data points point towards high valuations in equities, they may make sense in a bigger picture where bond yields have been held down by low Treasury yields and liquidity provided by the Fed. Lonski notes that long-term Baa industrial company bond yields averaged 8.28% in 2000 Q1 while the most recent average Baa industrial yield was 3.27% (it hasn't been this low since October 1952). Bringing bond yields into the picture makes frames the elevated valuations differently.
Yardeni Research's models showing the Fed Stock Valuation Model actually give evidence supporting an undervalued stock market when using both Treasury yields and corporate bond yields. The idea is encapsulated in the motif that investors are moved by a "search for yield" in whichever asset classes are most available to them. The Kansas City Fed illustrates this concept in a 2000 paper titled "The P/E Ratio and Stock Market Performance."
The visualization is constructed using a comparison of yields in stocks and bonds. The stock yield is represented by an earnings yield which is the inverse of a holistic P/E ratio, and bond yields by the Moody's Baa average corporate bond yield (but can be represented by Treasury yields which are used in the Kansas City Fed paper or other types of fixed income). The higher the spread is, the more stocks are yielding in comparison to bonds. The chart clearly shows that the suppression in bond yields has led to larger spreads since the Great Recession that are very far away from pre-dot-com bubble and pre-financial crisis spreads.
So yes, the market is exhibiting certain bubble-like features that give some investors warning, but in the greater context of the financial markets, those features seem irrelevant. The "search for yield" still seems to point at equities as the most opportunistic asset class in the financial sphere. That doesn't necessarily mean that every company is inexpensive and an opportunity for investors, but it does suggest that general stock market can drift higher from its current level.
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