Are stocks overvalued? Any number of “experts” are concluding that they are indeed overvalued. But are they? Really?

When I was a rookie stockbroker back in 1987, I cold called a prospect who told me the market was overbot and overvalued. The DOW at that time had broken through 1,700, and this prospect had pulled his money out of the market a month earlier and was waiting for the DOW to drop off to 1,300. I never talked to him again. I don’t know if he is still waiting after 34 years for DOW 1,300.

Those of us who stayed in the market have ridden that growth to 32,000.

I talk to some people recently who have sold out and are waiting for the sky to fall.

The most comprehensive study of valuations and inflation was done by Jeremy Siegel.[1] He studied the relationship between stocks, bonds, and inflation beginning in 1802, a period of over 200 year. What he found was this:

  • Short-term treasuries averaged 0.5% over the rate of inflation
  • Long-term treasuries averaged 1.5% over the rate of inflation
  • Stocks averaged 6.4% over the rate of inflation.

It is a relationship to risk. Short-term treasuries have little risk of default and relatively little risk of inflation devaluing the dollar over the short time before they mature. Longer-term bonds have little risk of default, but do carry the risk of inflation during the following decades. Investors would require additional return to compensate for the inflation risk. Equities have not only the inflation risk, but the risk of bankruptcy of the underlying companies. So investors require an even greater return for the added risk they assume in owning stocks.

So how does valuation at current levels stack up for stocks?

Inflation for the past 12 months, excluding the impact of food and energy, has been 1.7%. Stock valuations based on the 200-year study Siegel did says the real valuation of stocks would be 8.1%.

Taking the S&P 500 with dividends reinvested from March 1, 2000 to February 28, 2021, the annually compounded return on the stocks has been 4.686% above inflation or 6.757% after taking into account an inflation of 1.7% for the last 12 twelve months.

I use March 2000 because that was the peak of the market at the end of the 1979-2000 secular bull market. By using that data, we see the effects of both a bull and a bear on the market,

All of that to say, stocks are not overvalued according to a 200-year study. There is still room for growth.

Mike Adams

[1] Jeremy J. Siegel, “The Equity Premium: Stock and Bond Returns Since 1802,” Financial Analysts Journal 48 (1992): 28-38. Accessed March 15, 2021. http://www.jstor.org/stable/4479502.