Is the Market Overvalued?

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Is the Market Overvalued?

Larry Swedroe Jul 27, 2016

So today we’ll examine current market valuations to see if they seem “too high.” The following table shows current valuation metrics for the Vanguard 500 Index Fund (VFINX) and compares them to their 25-year average. The data for VFINX is from Morningstar as of June 30, 2016; the data for the 25-year average is from J.P. Morgan Asset Management.

**20-year average due to data available

This raises the questions: Are stocks really overvalued? And should we be expecting a major correction due to mean reversion? I just don’t see it in the data.

Estimating Future Returns

While 4.1% is well below the S&P 500’s historical real return of about 7%, with the current T-bill rate at just 0.25%, it still produces a significant equity risk premium (though lower than the historical level). Thus, at least in my view, it’s awfully hard to argue that the market is vastly overvalued and due for a correction.

In fact, it’s just as hard now as it was when Grantham first issued his warning of massive overvaluation (75%) in mid-November 2013, when the S&P 500 was at about 1,800. At the time, Grantham forecasted a real return to the S&P 500 over the next seven years of -1.3%. Although Grantham may yet turn out to be right, without even considering dividends, the S&P 500 has increased by more than 20%. Including dividends, the return would be greater than 25%. Examples such as these are why Warren Buffett advises investors to ignore all market forecasts, because they tell you more about the person making them than they do about the direction of the market.

One final note: I think it’s important to add that international valuations are much lower. For example, the current Shiller CAPE 10 for developed, non-U.S. markets is about 15, which produces a real return forecast of about 7.3%. For emerging markets, the Shiller CAPE 10 is about 12, producing a real return forecast of about 9.4%. Those return forecasts are roughly their historical averages, and they look even more attractive relative to the riskless alternative.

The Bottom Line

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