What Rate of Return Is the Market Implying?

23 Feb

Market pundits on CNBC continue to talk about the market being overbought at these levels and mentioning the likelihood that there could be a better entry point at which to put new cash to work. I tend to agree, as I look at market volatility at a nearly 20-year low (similar to this time last year) that is due to “revert to the mean.” So the market may be overbought and participants in general complacent about market risk, but is the stock market overvalued?

It’s hard to answer that question, of course, and I don’t know for certain. Various market participants use different methods to come up with the rate at which to discount the stock market’s future growth. And all have different returns they are willing to accept for the risk they take in equities. That’s not finance theory, but it’s the way I see it. I, for one, am always in a better mood when the markets are down and thus the implied future rate of return up.

Based on current S&P 500 Index levels, I calculate the implied future return on the market to be a little under 8.0% based on a long-term trend growth rate of 6%. This tells me that indexing from this level is likely to yield below-average future returns. So is the market overvalued? Well, are you willing to accept the added risk inherent in stocks for about 3% more than a 10-year Treasury? That’s really the long-term Treasury rate plus inflation. I see that as being fairly valued to slightly overvalued.

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