So I have recently been seeing lots of posts suggesting "the market" is overvalued and looking at the S&P's forward P/E it is just above 20, and all time highs have just been reached this could be frothy. I thought it would be interesting to have a broader discussion about what drives the market long term, perhaps to somewhat contextualise today's valuations.
One way to consider the S&P 500 would be to assume that the business' within it represent the US economy. Using figures for the past 30 years on the US average CPI inflation and real economic growth have both been around 2.5% and the current capital return of business' (dividend yield + buyback yield) is estimated to be about 3%. 2.5 + 2.5 + 3 = 8! So right there is your 8% return, if you are happy to make assumptions these trends continue.
However, this is overly simplistic for a few reasons. One of the first to point out, which is one reason why the market has done so well of late is that tax has been cut for large corporations in the US boosting profits, I won't go into this much more as taxes can fluctuate over time and over the long run I would say unless anything crazy happens they are just kind of "noise".
One of the most significant points is that it is unrealistic to suggest the S&P 500 represents the average of the US economy, rather it is the 500 largest and one major tailwind for the index has been the fact, especially with the rise of technology, that economic growth has disproportionately benefitted large firms and hence the index. Not only this, but the index is based on market cap and as such the winners are bought and the losers sold, it has inbuilt selection rules, also generating additional returns.
Furthermore, US firms are highly competitive in certain faster growing overseas markets, this can further raise growth.
You can see this outperformance factor based on the fact that the median ROIC of S&P 500 firms historically has been 10%, this is the return a business gets from investments and in the long run stock returns should converge to ROIC. In fact, due to higher tech exposure ROIC has edged up to 12% to 15%, whether this maintains as high (with AI) is a large question, but again has helped the index command a higher valuation.
Plus as more money has flowed into the market as investing has become increasingly democratised valuations have been pushed up, now as "baby boomers" begin withdrawing funds, what happens next here is uncertain but again, one tends to think with investing becoming so much easier, more accessible and cultural relevant, this trend could continue. Especially, if international investors warm back up to the US again.
So with a TTM earnings yield of 3.5% the equity risk premium has practically vanished. It is understandable people think valuations are too high. Are they too high? Well in reality who knows, we can say that over the long run the odds on your side but, truly nothing is certain.
Personally, I prefer the All-World index to the S&P 500, purely because I don't know whether the US will continue to outperform the rest of the world. However, I actually don't own either because gambling on individual stocks is fun ;) !