Who Says U.S. Stock Valuations Are Too High? Research Reveals P/E Ratio Blind Spot: S&P 500 Long-Term Returns May Be 'Underestimated'

Although current valuation metrics such as the P/E ratio generally indicate that the U.S. stock market is at a "high but cold" level, a recent academic study suggests that investors may have long misunderstood these valuation signals. The stock market may still deliver decent returns over the next decade.

According to Barron's Weekly, this research was jointly conducted by Sebastian Hillenbrand of Harvard Business School and Odhrain McCarthy of NYU Stern School of Business, titled "The Hidden Trend in Stock-Market Cash Flows."

The research argues that investors have long misunderstood how to interpret stock market valuation formulas, including common valuation metrics such as P/E ratio, cyclically adjusted P/E ratio, dividend yield, and the Buffett indicator.

Taking the S&P 500 Index as an example, its current P/E ratio is approximately 25.2 times, far exceeding Robert Shiller's long-term average of 16.2 times since 1871, and even surpassing 92% of historical records over the past 150 years.

Looking at the numbers alone, there is indeed cause for concern about overvaluation. However, the two professors believe that this analysis method is misleading.

Their core argument is that the volatility of valuation ratios is actually influenced by two different factors, but Wall Street has long focused almost exclusively on one of them: the economic cycle of market fluctuations between bull and bear markets.

From this perspective, the higher the valuation ratios such as P/E, the more expensive the market valuation, and the lower the expected future return rate.

However, the market often overlooks the "long-term upward trend in corporate earnings growth rates." The researchers point out that a higher valuation ratio does not necessarily mean that future expected returns are deteriorating; on the contrary, it may also represent the market's expectation that corporate earnings will grow at a faster pace in the coming years.

The research points out that the average P/E ratio of the S&P 500 over the past 30 years has reached 25.7 times, nearly double the average of 14.7 times over the 30 years at the end of the 19th century.

If we further compare the changes in earnings per share growth rates, the gap is even more striking. Over the past few decades, the annualized earnings per share growth rate of the S&P 500 has been approximately 7.0%, compared to an annualized growth rate of only 0.6% at the end of the 19th century.

The two scholars therefore believe that comparing today's P/E ratios with those of centuries ago is like "comparing apples and oranges."

However, it is not easy to distinguish how much of the current higher P/E ratios is due to valuation increases and how much is due to accelerated corporate earnings growth. The two professors break this down through complex statistical models.

Hillenbrand stated that the most important conclusion is that once the impact of accelerated corporate earnings growth is incorporated, the predictive power of valuation ratios for future returns will be significantly enhanced.

He pointed out that without this adjustment, most of the most popular valuation indicators, in out-of-sample prediction performance, are statistically almost no different from flipping a coin.

In addition, adjusting valuation ratios to reflect the long-term acceleration trend of corporate earnings growth rates will also increase the predicted value of future market returns.

To illustrate this point, Hillenbrand separately calculated the estimated future five-year and ten-year returns based on the unadjusted P/E ratio.

If no adjustment is made, the model shows that the stock market will remain roughly flat in the coming years; but after completing the adjustment, Hillenbrand estimates that the annualized return rate over the next five years can reach 7.0%, and the annualized return rate over the next ten years can reach 7.7%.

Although these estimated returns are still slightly lower than the stock market's long-term annualized average return of approximately 10%, compared to the negative returns originally predicted by many traditional valuation indicators, the overall outlook is much more optimistic.