By Daniel Archibald | CFA
It is now 8.5 years since the US market started on its current bull market run. A bull market might generally be defined as a period in which stock prices do not hit bear market territory. A bear market is generally defined as a market which has fallen more than 20% from recent highs. Over this same period, the Australian market has seen 20%+ falls on two separate occasions, and has pushed sideways for much of the past 4 years.
Being the largest and most important share market in the world, the stability and sustainability of the US market is of great concern to investors across the globe. The market bottom of 2009 saw the S&P500 touch just below 670 points and less than a decade later, the market is up above 2,550 points, an annual return of more than 17% p.a., or almost 20% p.a. If you include dividends. For those keeping score, the Aussie market has returned about 8% p.a. below this level (including dividends).
The sharp divergence might likely point to the relative expensiveness of the US share market. However, it is worth noting that the preceding decade saw a similar bull market for Aussie equities, with a similar divergence in fortunes for the US market. Hence the current outperformance by the US share market might simply be a restoring of global market balances. Also, the fact that the US market fell more than 50% in the year leading up to March 2009 , might also indicate that part of the current bull market returns have come simply from the market correcting the overpessimism from the GFC.
Rather than simply looking at share price gains, both absolute and relative, it is common for investors to assess the expensiveness of a market by looking at price-to-earnings (P/E) ratios. This is a quick measure highlighting how much investors are paying for the profits earned by companies. Furthermore, the cyclically-adjusted P/E ratio (CAPE) is an extension of this measure that looks to reduce the effect of volatility in short-term earnings.
In general, P/E ratios expand as earnings grow and/or become more reliable. They will also tend to increase as bond yields fall (which is the same as bond prices rising), as this indicates that investors are willing to pay higher prices for the same return.
Going back to 1871, the average CAPE ratio for the US market has been around 17.0, with the average over the last 30 years being closer to 20. As per the above, this increase in average is likely to do with the large drop in interest rate over this time, coupled with greater market efficiency and liquidity.
In general, when the CAPE increases too far beyond the average, the market is at risk of falling. In the year 2000, the CAPE ratio hit above 40 before the bursting of the tech-bubble saw it come back down to about 20. In 2007, it had increased back up to the high 20's, before the GFC sent it crashing down to below 15. The current CAPE ratio for the US market is sitting above 30.
Though this seemingly high measure of US market value is worrying, trying to figure out when and how the CAPE measure might revert back down to more stable levels is a complete unknown. In fact, the ratio can fall without a similar fall in stock prices should earnings continue to grow. However, with stock prices at such high levels, any major negative shock to system could spell the end of the running of the US bull.