Warnings of a stock market crash abound, and they are backed by rational arguments. Two recent examples on Real Money stand out. Doug Kass' excellent article on why the bull market is dangerous lists many of these arguments, with in-depth explanations. There is also this very good article by Ken Goldberg, who warns that equities are in "nosebleed zones."
However, there is one important argument against the idea that U.S. equities are overvalued, in the view of John Higgins, chief markets economist at London-based think tank Capital Economics. Using Gordon's dividend discount model, he argues that, contrary to the opinion of many market participants, U.S. equities are actually undervalued.
The well-known model looks at the price of the stock as a ratio of the expected dividend per share divided by the real rate of return required by investors minus the expected real growth rate of the dividend. The real rate of return is the risk-free rate -- in the U.S., it could be approximated by the 10-year yield on Treasury Inflation Protected Securities, or TIPS -- plus an equity risk premium.
Applying the formula to the whole of the stock market -- assuming that in equilibrium the market's equity yield (expected earnings divided by price) should equal the real return (the risk-free rate plus the equity risk premium) -- shows the equilibrium level of the equity yield has fallen as these other variables have fallen, according to Higgins.
Therefore, he believes it is misleading to compare the current level of the equity yield with its average level of the past, because expectations have shifted downward.
"We think that there has been a decline in the equilibrium level of the risk-free rate consistent with a reduction in the equilibrium level of the real federal funds rate. We also think that there has been a decline in the equilibrium level of the equity risk premium," he wrote in research released on July 11.
In Higgins' opinion, the prevailing equilibrium level of the equity yield is around 4% to 5%, much less than the 7% average since 1881 of Robert Shiller's cyclically adjusted earnings yield that is widely used in the markets.
"Of course, the equity yield will continue to fluctuate around its equilibrium level. But because we think that this equilibrium level is much lower than its long-run average, we don't expect the stock market to collapse under its own weight any time soon," Higgins wrote.
Looking at FactSet data on earnings expectations for the S&P 500 suggests the current equity yield is 5.4% based on expected earnings per share (EPS) for December 2017, and 6% on expected EPS for December 2018.
Higgins doubts the stock market will fall sharply until 2019, when economists at Capital Economics expect the U.S. economy will be faltering.
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