[Financial Planning for the 100-Year Life] Risk Management Needed for US Stock Investors

Price-to-Earnings Ratio and Market Capitalization Overvalued
Real Interest Rate Turns Positive... Risk of Stock Price Decline

After experiencing a correction in August, U.S. stock prices are rising again. However, stock prices remain overvalued relative to corporate earnings and macroeconomic variables. The overvaluation may be resolved soon as stock prices decline.

Let's look at several indicators that show the degree of stock overvaluation. First, the price-to-earnings ratio (PER). As of the 29th, the S&P 500's PER is 25.7, which is 60.6% higher than the long-term average (16.0, from January 1870 to August 2023). Second, the S&P 500's dividend yield is also very low at 1.53%, compared to the long-term average of 4.26%. This means stock prices are high relative to corporate earnings.

Third, the stock market capitalization is also high compared to nominal Gross Domestic Product (GDP). The total U.S. stock market capitalization reached a record high of 329% of GDP in the fourth quarter of 2021. Although it decreased to 259% in the first quarter of 2023, it remains much higher than the long-term average (110%, 1952?2021). The average from 2000 to 2021 was 186%, so the current level is even higher. Assuming nominal GDP grows by 5.5% this year, the appropriate level for the S&P 500 would be around 3,653 points. Fourth, considering key U.S. economic indicators such as industrial production, retail sales, employment, and broad money supply (M2), stock prices at the end of July were about 15% overvalued.

So, what factors could resolve the overvaluation of stock prices? If the U.S. economy, centered on consumption, falls into a recession due to the lagged effects of rising interest rates, corporate sales and profits may decline, leading to a drop in stock prices.

Recently, the yield on the U.S. 10-year Treasury note rose to 4.3%, marking the highest level since November 2007. The rise in interest rates is increasing the burden of principal and interest repayments on households. The ratio of principal and interest repayments to disposable income, which was 8.3% in the first quarter of 2021, rose to 9.6% in the first quarter of this year. In particular, the share of interest payments in disposable income increased significantly from 1.3% in January 2021 (an average of 1.9% since 2010) to 2.4% in June this year. This implies that consumption may decrease accordingly.

Rising interest rates are also expected to affect investments by highly indebted companies. In the first quarter of this year, U.S. corporate debt (= borrowings from financial institutions + corporate bond issuance) was 48.0% of GDP, down from 53.5% in the first quarter of 2021 but still higher than the post-2000 average of 43.8%.

As of last year, consumption and capital investment accounted for 70.6% and 14.7% of U.S. GDP, respectively. If consumption and investment shrink due to rising interest rates, the U.S. economy could enter a recession. Such a phenomenon is expected to appear as early as the fourth quarter of this year.

Rising market interest rates are also expected to impact asset prices. The 30-year fixed-rate mortgage interest rate exceeded 7% for the first time since 2001. This interest rate level makes it difficult for U.S. households to borrow money to buy homes. Consequently, housing transactions, mainly existing home sales, are declining. For example, the annualized number of home sales dropped sharply from 6.65 million in January 2021 to 4.07 million in July this year. Following the decrease in transaction volume, housing prices are also expected to fall.

Rising interest rates, especially real interest rates (= 10-year Treasury yield minus consumer price inflation), are expected to be a factor in stock price declines. Real interest rates were negative from August 2019 to May this year. In March 2022, real interest rates hit a record low of -6.4%. However, as interest rates rose and inflation slowed, real interest rates turned positive starting in July this year.

Statistical analysis since 2000 shows a correlation coefficient of -0.75 between real interest rates and the S&P 500. This means that when real interest rates rise, stock prices tend to fall. For U.S. stock investors, it seems to be a time when partial risk management is necessary.

Kim Young-ik, Adjunct Professor, Graduate School of Economics, Sogang University

This content was produced with the assistance of AI translation services.