As the stock market's rally passed the one-year mark this week, the debate raged: After a 60-per-cent rally from the lows, are equities now overvalued?
Based on one increasingly popular measure, the answer appears to be "yes."
Yale economist Robert Shiller's normalized price-to-earnings ratio - which looks at 10-year average earnings, in order to smooth out shorter-term hiccups within the economic cycle - shows the S&P 500's P/E running at about 20 times, well above its historical norm (in other words, its typical fair value) of 15 times.
But maybe the historical norms no longer apply, says David Bianco. The Bank of America-Merrill Lynch chief U.S. equity strategist argues that higher P/Es can be justified, given that investors now face some of the lowest costs of investing in history.
HITTING THE NET Implicit in stock valuations are the returns investors expect from their investments. But while equity returns are typically looked at in gross terms, the net returns investors can expect have actually been improving for decades.
That's because the key costs of investing have all been in decline. Mutual fund fees and expenses are half of what they were 20 years ago. Inflation and interest rates are a fraction of what they were 30 years ago. Investment tax rates have been cut in half since 1980.
If investors face lower costs, Mr. Bianco reasons, the market should be willing to pay more for the same amount of gross growth potential. So, higher P/Es may be entirely justified.
By Mr. Bianco's calculations, the drop in ownership and transaction expenses could justify 3 points of additional P/E over the historical norms, as would the lower tax rates. Low risk-free interest rates and low inflation would justify one more point. Combined, the improved potential returns on this "triple-net" basis suggests a P/E fair value of 22 times.
WATCH THOSE RISKS The impact of these costs is visible in reverse in the 1970s. At the time, the costs imposed by inflation and interest rates were sky-high - and the stock market was dead in the water.
At present, there appears to be a disconnect between the low real cost of equity investing and returns - costs are low and, yet, so is market performance. It suggests that the markets have loads of upside.
But Mr. Bianco cautions that this could be tempered by offsetting factors - namely, the perceived risks of increased market volatility, still-leveraged balance sheets and uncertain potential for long-term corporate growth.
While he doesn't quantify how much this higher risk premium and lower growth potential could weigh down P/E potential created by the lower cost factors, he says his analysis at least "suggests that it is very difficult to justify a P/E beneath history, given the substantial buffer that these factors provide."