Many people think that stocks are currently overvalued, because price/earnings ratios are nowadays much higher than historical averages (see for example here and here). Are they right? To answer this question, let's take a closer look at the valuation of stocks. The value (V) of any financial asset is determined by expected future cash flows (CF) and the required rate of return (r), with (simplified): V = CF / r.
If stocks are currently overvalued, this may be because investors overestimate expected future cash flows, i.e. company earnings. While this is probably true for some companies (Tesla Motors comes to mind, but who knows?), it seems doubtful to me that this applies to the overall market. There is currently a broad sense of pessimism about future economic growth (cf. the secular stagnation debate) and it is often argued that firms hold too much cash and don't invest enough. Not exactly an environment in which you would expect investors to be overly optimistic about the growth prospects of firms.
So, maybe then the return required by investors is too low? The required return on stocks consists of two parts: the risk free return plus an equity risk premium which takes into account that stocks are more risky than fixed return investments. Perhaps the equity risk premium should be higher? This is also doubtful: Aswath Damodaran, who is one of the smartest guys around when it comes to valuation, calculated that the equity risk premium for S&P 500 firms did not at all decline in the past five years. And why would the equity premium currently be too low?
Is the risk free return the culprit then? At first sight, this seems to make sense: central bank policies in the US, Europe and Japan (Evil Quantitative Easing) have driven down intrest rates (well, at least that's what is generally assumed, but I'm not aware of any hard evidence on this). The risk free return can be broken down in two components: expected inflation plus the "real intrest" that investors want for parting with their money.
It could be that current risk free returns insufficiently take into account future inflation. Indeed, people have been arguing for years that the QE policies pursued by central banks wil inevitably lead to high inflation. However, it seems very unlikely that stocks are overvalued because future inflation is underestimated. First, it is doubtful that quantitative easing will lead to high inflation. More importantly, whatever your belief about the impact of QE on inflation, inflation should not matter that much for stock returns. As I have explained in a previous post, stocks seem to provide a pretty good hedge against inflation: if inflation goes up, the firms' cash flows also go up (*). If you expect high inflation, you're better off with stocks than fixed income securities!
This brings us to the last reason why stocks might be overvalued: current intrest rates underestimate the "true" intrest rate, leading to too low discount rates. Central bank policies could temporarily have driven real intrest rates below "normal" levels, and stock investors insufficiently take into account that sooner or later real intrest rates will go up again, which will bring down the value of stocks. Here, Damodaran again provides a very useful perspective. He points out that in the long run, the real intrest rate has to backed up by a real growth in the economy. He finds that the intrest rate on US Treasury Bonds in recent decades is indeed strongly correlated with the sum of actual inflation rate and realized economic growth rate, which is a proxy for the "intrinsic" intrest rate, i.e. the sum of expected inflation and expected real economic growth. Furthermore, this relation seems hardly to be affected by QE, at least in the US. This suggests that current real intrest rates probably provide a not-so-bad reflection of the "true" intrest rate, irrespective of QE in recent years. Now, maybe investors do underestimate the "true" intrest rate because they underestimate future economic growth, leading to a discount rate being used to value stocks that is too low. However, if this is the case, then expected future company earnings are probably also too low, implying that the value of stocks might actually be underestimated and stock prices are too low.
Bottom line: even stock valuations are currently very high from a historical perspective, there are good reasons to believe that stocks are generally not overvalued. Yes, current stock valutions are based on low discount rates, but (a) low discount rates could reflect a new "normal" (as e.g. Robert J. Gordon has pointed out, we may have entered a new era of permanent low economic growth); and (b) even if economic growth picks up again leading to higher required rates of return, this economic growth should also lead to higher company earnings, increasing the value of stocks. A final point: if stocks would be overvalued, it doesn't make sense to shift your money to alternative investments such as bonds or real estate, if these alternatives are also overpriced.
(*) And as I always tell my students, you need be careful not to discount real cash flows (which do not incorporate expected inflation) with nominal discount rates (which do take into account expected inflation).
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