Why U.S. equity valuations continue to climb

Forecasting the fair market value of U.S. equities is akin to finding the Holy Grail.

At least, that’s the comparison made in a research report by Research Affiliates. Buy-and-hold strategies are failing, says the report, because normalized prices (adjusted for changes in earnings or dividends) have remained above long-term averages over the last quarter century.

Read: How do your clients define ‘long term’?

Why are valuations steadily increasing, and when will the trend reverse?

Read: Will U.S. equity valuations keep climbing?

The report examines the theory that rising valuations are fueled by large reductions of macroeconomic risk in the U.S. economy. “Investors are glad to pay a higher price, and accept a lower return, for investing in a stock market that delivers less uncertainty,” says the report.

Indeed, by plotting historical data, the report finds a significant positive correlation between expected real equity returns and the aggregate volatility of the economy.

And, when measures of real output growth and inflation are reviewed, the annual volatility of the economy has fallen 80% today, compared to pre-Fed days, says the report. Academic research suggests this reduction is due to technological innovation, greater market integration and superior policy, such as inflation targeting.

Since lower volatility justifies a higher fair value than the historical average, the current price of the stock market is expensive.

Using predictive models, the report finds that contrarian strategies, in which investors profit from prices reverting to longer-term averages, have underperformed because they haven’t been adapted to changes in the macroeconomic environment. To recognize fair value, investors must consider macroeconomic volatility.

Concludes the report: “Long-term investors can benefit by considering the future trajectory of economic management, both in the U.S. and abroad, and successfully advance their progress in the quest for […] fair value.”

Read the full report.

Also read: Rising rates call for a strategic allocation to low vol

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.