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Equities: Overvalued or undervalued?

11 April 2018 | Markets and Economy

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We believe traditional price/earnings ratios aren't an accurate barometer of stock market valuations. Here's how Vanguard makes market assessments.

Lara de la Iglesia (moderator): The stock market can be volatile, right? We all know that. You trade risks for the prospects of higher returns. But those risks have really been on display recently, so I have to ask, given that, what's our outlook for the global stock market right now?

Roger Aliaga-Díaz (Vanguard chief economist, Americas): Yeah, our outlook over the next ten years, let's say, is a little bit subdued compared to historical averages. It's in the order of 4.5% to 6.5% over the next ten years for the global market, perhaps a little bit lower than that for the US equity market in particular.

And it's important to remind investors although periods of high volatility that we went through naturally raises some questions about the prospects of the market here the idea is more to think about the long term, basically what the equity markets can do for your portfolio over the medium and long term. So the idea is not really to make a market call. It's much more about trying to recalibrate expectations, basically give a more realistic assessment of what investors can expect in their portfolios so they can make better decisions, strategic decisions related to saving or basically what are the odds of successfully achieving their investment goals.

Lara de la Iglesia: So, Harsh, your team manages the tool that Vanguard uses to look at equity market valuations. Tell me a bit about that.

Harshdeep Ahluwalia (Vanguard senior investment strategist): Sure. Our view of whether the stock market is overvlaued or undervalued is based on a valuation metric called the CAPE, which is a Cyclically-Adjusted P/E ratio. Price-to-earnings ratio.

A more traditional valuation metric, or price-to-earnings ratio, uses a 12-month trailing average for earnings. Now the Cyclically-Adjusted P/E ratio uses a 10-year average inflation-adjusted earnings metric.

And we can use this metric to determine if the equity market is over or undervalued. At the current time, the CAPE is above its long-term historical average; and this can cause some investors to conclude that the US equity market is extremely overvalued, like it would be in a bubble.

Lara de la Iglesia: Okay.

Roger Aliaga-Díaz: Well here it's important to point out that, to Harsh's point, many investors or analysts compare these ratios like the price-to-earning and the CAPE to historical average. So one thing that's important to keep in mind is also what is the market environment and the economic environment in which you're looking at the market.

For example, because of very low interest rates and very low inflation, such as the current period, it leads naturally to levels of valuation that are higher. And in that sense, one needs to adjust a little bit this comparison. Sometimes comparing to the historical average could be a little bit misleading.

Lara de la Iglesia: Okay, so Vanguard's developed a more comprehensive way of doing this, and I want to ask about that. Harsh, we've recently published some research on that in the Journal of Portfolio Management. Can you share with me what does Vanguard's method include?

Harshdeep Ahluwalia: Sure. Here at Vanguard we've developed a metric called a Fair-Value CAPE, which essentially adjusts the CAPE for the current levels of inflation and interest rates. So this Fair-Value CAPE provides a better benchmark for comparison against the CAPE, unlike the historical average.

So at present, the CAPE is slightly above our Fair-Value CAPE, but this kind of points us to the fact that the market is overvalued; but it's not extremely overvalued, as it would be in a bubble.

Lara de la Iglesia: An important point for our investors to remember.

Roger Aliaga-Díaz: Right, so little return but not as strongly negative as you may infer from just looking at historical averages.

Lara de la Iglesia: Yes, all right, thank you.

Related:

A new way to value the market: The "fair-value" CAPE

Important information:

This video is designed for use by, and is directed only at, persons resident in the UK.

This video was produced by The Vanguard Group, Inc. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

The opinions expressed in this video are those of the individual speakers and may not be representative of The Vanguard Group, Inc.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Issued by Vanguard Asset Management, Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.

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