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Stocks Overpriced?

STOCK MARKET valuations have been higher than the historical averages for much of the past three decades. For instance, since year-end 1989, the stocks in the S&P 500 have traded at an average 24.3 times trailing 12-month reported earnings, versus 13.5 for the 40 years prior to that. Similarly, the S&P 500’s dividend yield has averaged 2.1% since 1989, versus 4.1% for the prior four decades.

Faced with those sharply higher valuations, pundits have regularly warned that a great reckoning is at hand and that share prices will soon revert to more normal valuations. But the great reckoning hasn’t come to pass.

Why not? Some observers contend that today’s higher valuations should be expected, given the subdued inflation and falling interest rates of the past three decades, and that we’ll see more normal valuations if interest rates and inflation climb. There’s certainly merit to that argument: If bonds—the main alternative to stocks—are offering lower returns, stock do indeed become more attractive, so it’s rational for investors to bid up share prices.

But while lower interest rates may partly explain today’s higher valuations, arguably they don’t explain them entirely. Instead, it seems three other factors may also be at work.

First, investment costs have fallen sharply since the mid-1970s. If investors have a target after-cost rate of return, they can now achieve that target with lower pre-cost results—thereby justifying today’s higher stock and bond valuations, and hence lower expected returns.

Second, after decades of prosperity, investors may now have a greater appetite for risk. To be sure, the 2008-09 Great Recession was a wakeup call, but the economic pain was far less than that inflicted by the Great Depression of the 1930s. Result: Investors today are more comfortable owning stocks, with their potential for superior long-run performance.

Finally, as the world has grown richer, the pool of financial capital has grown larger. That capital is chasing a limited array of investment opportunities—and all that buying pressure has not only driven bond yields down, but also share prices higher.

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