U.S. Stock Market Valuation Already Too Rich: Experts

Just three years into the bull market and in an environment of low interest rates and subdued sentiment, the U.S. stock market's valuation is already too rich, say asset management firm GMO LLC's Ben Inker and other investment experts.

Conventional wisdom may actually argue that stocks are currently cheap.

The 12-month forward price-to-earnings ratio of 13 is below the long-term average of 16. The 10-year Treasury yield, currently at 1.99, is also barely above the dividend yield of the stock market, when historically the former is much higher. Moreover, sentiment of Wall Street and the general public is not the wildly optimistic mood associated with bubbles, as was the case in 1999 or even 2006.

However, the cyclically adjusted P/E ratio, or CAPE, which takes inflation-adjusted averages of prices and earnings for the trailing 10 years, is about 23, which is well above the long-term mean of 16.

Inker, head of Boston-based GMO's asset allocation group, which uses long-term averages of P/E ratios and profit margins for stocks, stated that stocks are expensive relative to our estimate of long-term fair value in the firm's latest quarterly letter.

GMO expects the annual volatility, or risk, of the stock market to exceed its annualized real returns for the next seven years, an unattractive proposition for investors.

Economist Andrew Smithers of Smithers & CO, an asset allocation advisory firm, estimated that U.S. stocks were overpriced by 50 percent in late March, according to CNBC.

Smithers' calculations were based on CAPE and a ratio of stock prices to companies' net worth measured by replacement cost.

He noted that when the stock market was overvalued by a similar degree in the past -- as in 1906, 1937 and 1968 -- long secular bear markets followed.

(Smithers's and others, however, noted that current valuations are still well off the historic anomalies of the 1929 and 1999 bubble years.)

Today's puzzling case of stock market overvaluation in an environment that usually signifies fair or undervaluation is explained by the Federal Reserve's ultra-loose monetary policy, which drives down the yields of fixed-income instruments and pushes investors into risky assets like stocks, says Inker.

Moreover, by driving down yields, the Fed has also made bonds expensive, leaving investors with few traditional investment choices.

As seen in the chart below, GMO thinks the entire stocks and bonds space has become more overvalued in 2012, certainly when compared with 2009 levels.

The advantage of bonds, however, is that when they fall in price and revert to their lower historic valuation, the losses will likely be smaller when compared to stocks, according to Inker.