Valuation, Observability of Valuation Drivers, and Future Stock Returns

Abstract

This article shows that the relationship between favorable equity market valuations and subsequent equity market returns depends on the extent to which the reasons for such valuations are likely to be observable to investors. The authors use the Implied Equity Risk Premium (ERP) to measure whether the U.S. equity market is favorably valued, and a macroeconomic model to explain the level of ERP and allow a determination of whether valuations are consistent with observable data. The model for explaining ERPs considers factors such as interest rates, GDP growth, analysts’ longterm growth forecasts, and investors’ preference for equities with high asset value relative to investors’ preference for equities with high future growth opportunities. When the reasons for the favorable valuations are likely to be known to investors, such as when the negative macroeconomic data consistent with current ERP levels are already public information, higher ERPs are predictive of higher future stock market returns in the long term. However, when the reasons for the favorable valuations are not as likely to be known to investors, higher ERPs are predictive of lower stock market returns in the short term. The rationale is that investor concerns that lead to higher ERPs are more likely to be fully priced when those concerns reflect data that are publicly available, setting the stage for higher future returns. The relevant implication for investors is that valuation is not a sufficient signal for increasing equity allocations. Rather, even if valuation appears attractive, investors should wait to increase equity allocations until the valuation level can be explained by observable data.