One camp argues that the market is dangerously overvalued. The so-called CAPE ratio—the price-earnings multiple for the market based on cyclically adjusted earnings averaged over the past 10 years—stands at over 25, well above its long-run average of about 15. Today's CAPE has been exceeded only during the market peaks of 1929, early 2000 and 2007.
Another group of forecasters are convinced that stocks are reasonably valued. The main competitors for stocks in individual and institutional portfolios are bonds. And yields on fixed-income securities are at all-time lows. Short-term interest rates are essentially zero, and the yield on the 10-year U.S. Treasury bond is only 2.4%. Investors seeking a reasonable rate of return have few places to go other than equities. This camp believes equities are a particularly attractive option in the menu offered by today's capital markets.
If we add three or four percentage points to the current low Treasury yield, we still get a low discount rate that can justify high stock prices. And today's low interest rates may persist. The world is likely to experience a long period of abundant productive and labor capacity with attendant slow growth, along with low interest rates.
While continued low rates can justify high stock prices, the CAPE followers are correct as well. Long-run equity returns from today's price levels are likely to be considerably lower than their 10% long-run average.