Robust economic data and optimism over US tax reform have driven the S&P 500 to a series of record highs. Some now believe that US stocks are looking a little overbought, but Capital Economics doesn't expect a bubble to burst in 2018.
Analyst John Higgins notes, however, that the Shiller cyclically-adjusted price earnings (CAPE) ratio for index has climbed to near 32.
He says: "The last time it rose to such a high level was in the late 1990s, shortly before equity prices in the US plunged."
But this is no reason why investors should immediately switch their tactics to short US stocks in the coming weeks.
A better CAPE measure?
Higgins notes that the main demoninator for the CAPE ratio is a ten-year average of earnings per share measures that is still being depressed by the last recession of 2009/10, which resulted in widespread asset writedowns.
A more accurate measure would be an average of operating earnings per share - "a better guide to underlying earnings", says Higgins. This is higher with the result that Shillers CAPE is roughly 5 points lower when this measure is chosen for the denominator. (See chart)
Moreover, says Higgins, earning per share have grown significantly in the US since the recession, so they are higher now than on average during the prior decade. Considering this, the operating EPS CAPE ratio would be as low as 20.
Higgins says: "The bears might claim that 20 is still an unsustainably high level because the average of the P/E ratio dating back over a hundred years is closer to 14.
"But this fails to take account of structural changes in the economy. When the stock market is in equilibrium, its P/E ratio will be the reciprocal of investors’ real required return from equities," he adds.
The bearish argument, therefore, is same as arguing that it is irrational for investors to require a real return from equities of 5% today, when, in the past they've returned closer to 7%.
Equilibrium is lower today
"We disagree," says Higgins. "This is because the required real return from equities is influenced by the required real return from 'risk-free' assets, whose equilibrium level has fallen in recent decades alongside that of real short-term interest rates."
Factoring in these elements puts the equilibrium required real return from equities today at around 4-5%, Higgins suggests.
"If so, the stock market is not grossly overvalued at all."