Is the US equity market overvalued?

After the S&P 500 index set a new record closing high last Wednesday, up some 6% since the US presidential election, I am left once again scratching my head over the age-old question: is the US equity market expensive or cheap?

The answer is... the S&P 500 is either significantly overvalued, or roughly in line with its fair valuation, depending on how you look at it. If I look at the index on a standard capitalisation-weighted basis, then the S&P 500’s valuation is more or less in line with where my model indicates it should be. But if I look at the same 500 index constituents on an equally-weighted basis, then the S&P 500 looks way overvalued relative to my model, as the chart shows.

These divergent observations lead to the question: how do I construct my model? The answer is in two stages, based on two parameters:

- The first parameter is US corporate earnings. However, I do not use S&P 500 earnings as reported by the constituent companies. I have very little confidence in the veracity of the corporate earnings reports, which are heavily distorted by creative accounting, especially around turning points in the business cycle. Instead, I use corporate earnings as published in the US national accounts. Over the long term, these show the same growth rate as reported S&P 500 earnings, but they are subject to fewer revisions over the shorter term.

- Now I have got relatively reliable figures for corporate earnings, I need to discount them by an appropriate cost of capital. The usual method is to use the yield on long-dated (10 years or more) US treasury bonds. The trouble with using this rate is that there have been numerous periods in the past when the treasury market itself was either overvalued or undervalued.

For example, in 1981 the bond market was massively undervalued, so any market model based on long rates naturally showed that equities were massively overvalued. As subsequent history taught, that was plainly wrong. So, instead of using the market yield as my discount rate, I prefer to use the rate at which long bond yield should have been trading in a perfect world. This I take as the seven-year moving average of inflation plus 2.5pp, which is roughly the structural growth rate of the US economy (although that looks increasingly questionable these days).

Once I have these two parameters, I can compute a valuation model for the stock market based on corporate earnings adjusted for the “theoretical” cost of capital. This gives me both a long run central valuation and a standard deviation. When the index is above the upper limit of the one standard deviation band, the market is deemed to be overvalued. When below the lower limit, it is deemed to be undervalued.

Since 2002, and even more so since the financial crisis, there has been an extraordinary divergence between the cap-weighted and equally-weighted S&P 500 indexes, with the equally-weighted index outperforming the cap-weighted index by around 50%, something unprecedented since 1990, which is as far back as I have data for the equally-weighted index.

This must mean that today the median share in the S&P 500 is way overvalued, but that a small number of very large cap stocks are cheap. This is the reverse of the situation that prevailed at the height of the 2000 tech bubble, when most shares in the index were only moderately overvalued, but a handful of very large cap stocks were eye-wateringly expensive.

For investors who like to be indexed, the logical solution back then was to shift from a market cap-weighted index to an equally-weighted index.

In the following three years, the capweighted index went down almost -50%, while the equally-weighted index fell by a much more bearable -25%. In the subsequent cycle, from the market bottom of 2003 to the bottom of 2009, the two indexes delivered roughly the same return.

Since then, things have changed. From the bottom of the market in March 2009, the S&P 500 equally-weighted index has quadrupled in value, while the capweighted has climbed by a “more modest” 300%.

If I were still responsible for managing money, and if I wanted to stay fully invested, at this point given the relative valuations of the two indexes comprising exactly the same constituents, I would sell the equally-weighted index and buy the cap-weighted index. The opposite was a nobrainer in 2000. This is a no-brainer today.