Setting realistic expectations
August 19, 2024
Rebounding corporate earnings growth and expected relief from tight interest rate policy boosted U.S. stock prices in the second quarter. Some sectors within the U.S. market still appear to offer value, particularly value and small-cap stocks. Comparatively low valuations for international equities stand in sharp contrast to the lofty prices of U.S. equities in general. At the end of June, the price-to-earnings ratio for the S&P 500 was in the 99th percentile of our estimates of fair value.1 (Valuations for value and small-cap stocks are relative to the valuation of the broad U.S. equity market.)
Bonds, meanwhile, mostly remain fairly valued or undervalued in a higher-interest-rate environment.
“In the second quarter, we saw a continuation of the story of lower long-term expected returns in the U.S. equity market, due to high valuations within it and reasonable expected returns outside the United States,” said Kevin DiCiurcio, CFA, head of the Vanguard Capital Markets Model® (VCMM) research team. “Our expected returns for stocks and bonds over the next 10 years are very close. The premium for taking equity risk is very narrow.”
It’s important to keep in mind that changes in valuations are only one part of total return. For equities, the other factors are earnings growth, dividends, and the currency effects of holding international shares. Valuations tend to be poor predictors of performance over the short or even intermediate term and should not serve as a primary reason for changing portfolio allocations. Over the long term (generally 10 years or more), we believe that valuations tend to revert toward average levels consistent with the interest rate and inflation environment.
Potential opportunities and cautionary signals for long-term investors
Notes: The U.S. equity valuation measure is the current cyclically adjusted price/earnings ratio (CAPE) percentile relative to our fair-value CAPE estimate for the MSCI US Broad Market Index. Factor valuations are relative to U.S. equities as the base at the 50th percentile. Growth, value, and small-cap valuation measures are all based on the percentile rank based on our fair-value model relative to the market. The large-cap valuation measure is a composite valuation measure of the style factor to U.S. relative valuations and the current U.S. CAPE percentile relative to its fair-value CAPE. The emerging markets valuation measure is based on the percentile rank based on our fair-value model relative to the market. The ex-U.S. developed markets and global ex-U.S. equity valuation measures are the market-capitalization-weighted CAPE percentiles relative to our fair-value CAPE estimate for the MSCI EMU Index, MSCI UK Index, MSCI Japan Index, MSCI Canada Index, MSCI Australia Index, and MSCI Emerging Markets Index; the MSCI Emerging Markets Index is used only for global ex-U.S. equities.
Aggregate bond valuation measures are market-capitalization-weighted averages of intermediate-term credit and Treasury valuation percentiles for the U.S. and global ex-U.S. (market-capitalization-weighted averages of the euro area, the U.K., Japan, Canada, and Australia). Treasury valuation measures are the key rate duration-weighted average of our fair-value model. Intermediate credit, high-yield credit, mortgage-backed securities (MBS), and emerging markets sovereign debt valuation measures are based on current spreads relative to the VCMM simulation of spreads in year 30 of our forecast. The Treasury Inflation-Protected Securities (TIPS) valuation measure is based on the 10-year annualized inflation forecast relative to our equilibrium forecast for inflation.
The valuation percentiles are as of March 31, 2024, and June 30, 2024.
Source: Vanguard calculations using data from Robert Shiller’s website at aida.wss.yale.edu/~shiller/data.htm, the U.S. Bureau of Labor Statistics, the Federal Reserve Board, and Refinitiv, as of June 30, 2024.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of March 31, 2024, and June 30, 2024. Results from the model may vary with each use and over time. For more information, please see the Notes section below.
1 Our fair-value measure of the market’s cyclically adjusted price/earnings (CAPE) ratio starts with the CAPE metric established by Robert Shiller of Yale University. That measure reflects the last 10 years of corporate earnings, which smooths valuations based on current prices and profits. We build upon the Shiller CAPE by estimating fair values in relation to prevailing interest and inflation rates.
Notes: All investing is subject to risk, including the possible loss of the money you invest.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
CFA® is a registered trademark owned by CFA Institute.
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