Asset management company GMO estimates that S&P stock index is highly overvalued.
In GMO’s quarterly letter, Ben Inker, co-head of global asset allocation at GMO argues that the expected rate of return on the stock market index is negative, adjusted for inflation, for the next seven years.
“On the new model, fair value for the S&P 500 is about 1100 and the expected return is -1.3% per year for the next seven years after inflation”, Inker says.
GMO focuses on average return of sales. According to Inker, return on sales has looked fairly stable historically, but now average return on sales is significantly above normal profit margins. This approach makes valuations look extremely high.
“Combining the current P/E of over 19 for the S&P 500 and a return on sales about 42% over the historical average, we would get an estimate that the S&P 500 is approximately 75% overvalued”, Inker says.
Although, historically sales margin has been mean reserving. Therefore, GMO assumes that profit margin on sales would revert to something higher than its long-term average.
Based on these assumptions, the implications are radical. According to Inker: “the U.S. stock market is trading at levels that do not seem capable of supporting the type of returns that investors have gotten used to receiving from equities.”
