by Goldman Sachs
Highlights
• US equity valuations are at historically high levels, and there is increased focus on whether this is a cause for concern. In this Analyst, we take a fresh look at equity valuations and returns from a macro perspective. We find that unusually low bond yields, low inflation and a rapidly improving labor market are conditions that should be associated with unusually high valuations. As yields rise and labor market improvement eases, however, the macro support for valuations is likely to erode.
• Three main points illustrate the importance of macro drivers to thinking about equity valuations and returns. First, treating equities as a perpetual bond that delivers an “earnings yield” (the inverse of the price/earnings ratio) provides a pretty good approximation for US equity returns. Second, what matters most is not whether equity valuations are high but whether they are higher than they“should” be given the macro backdrop. Third, an accurate forward view of three macro drivers—bond yields, the unemployment rate and inflation—would generate much better return predictions for US equities at all horizons.
• Our macro model of equity valuations implies that valuations are roughly fair given today’s macro environment. This is a different story to the last time earnings yields (equity valuations) were at or below (above) current levels in the late 1990s. The macro support for equity valuations is set to weaken going forward, however. We are forecasting that bond yields will rise steadily and the pace of improvement in the jobs market will ease as we move into 2022 and beyond. Although our macro forecasts still justify above-average valuations, they imply headwinds from current levels. If the market is unwilling to view the recent rise in inflation as transitory or the recent slowing in jobs growth is more persistent than we expect, those valuation headwinds could come earlier and prove stronger.
Copyright © Goldman Sachs
