Higher interest rates can be a headwind for asset prices. The U.S. bond market has adjusted to them, as reflected in bonds’ sharp price drops over the past two years. The equity market, on the other hand, has continued to hit fresh highs, suggesting investors may be too complacent about expanding valuations.

Where valuations stand today

Valuations—the market’s view on how much companies are worth—are looking a bit frothy. The chart below shows a common metric for valuing the U.S. equity market—the cyclically adjusted price/earnings (CAPE) ratio. To smooth out the impact of economic cycles, it considers current share prices in the context of 10-year inflation-adjusted earnings per share. In January 2024, the CAPE ratio for U.S. equities was over 30, higher than in most periods of the last 70 years.

But what we think of as fair value for shares depends in part on the macroeconomic environment, including interest rates, inflation, and market volatility. Higher share market valuations can be justified during periods of low interest rates, low inflation, and low volatility. The low rates push down the discount rate and the cost of a stake today in a company’s future earnings.

U.S. equity prices have climbed to new highs even as the transition to a higher-interest-rate environment has depressed our estimate of where fair value lies. The widening gap between equity prices and our assessment leaves the U.S. equity valuation about 30% above our estimated range of its fair value.

For context, U.S. share valuations have rarely been this high. Their valuation today is at the 99th percentile, a level paralleled since 1950 only by the dot-com bubble and the post-COVID reopening.

How the valuation gap could close over time

A fall in interest rates could help close the valuation gap. Although we expect policy interest rate cuts in the U.S. this year, we don’t expect them to be enough to significantly increase our fair-value estimates. Beyond 2024, the fair-value range is unlikely to revert to levels that prevailed at the start of the decade. The era of near-zero interest rates is behind us.

It’s much more likely that the gap would close through falling equity prices.

The risk of a correction in equity prices has risen as valuations have become more stretched.

What valuations can and can’t tell us

Valuations are a strong indicator of long-term equity returns. And that doesn’t bode well for the U.S. equity market given where valuations currently sit.

I’d caution, however, that while valuations are undoubtedly high right now, that doesn’t mean they can’t go higher in the near term. They are not a market-timing tool. And even over extended periods, valuations are not infallible predictors of outperformance or underperformance.

That’s why, even with our more guarded outlook forU.S. equity returns over the next decade, we would not encourage investors to make drastic changes to their asset allocation.

Diversification is the healthy option

Regardless of the return outlook for U.S. stocks, having a mix of assets that are not perfectly correlated helps reduce risk in a portfolio. Just as living a balanced life is conducive to good health, finding balance in an investment portfolio gives investors a healthy chance of achieving their long-term financial goals.

Notes: This article contains certain 'forward looking' statements. Forward looking statements, opinions and estimates provided in this article are based on assumptions and contingencies which are subject to change without notice, as are statements about market and industry trends, which are based on interpretations of current market conditions. Forward-looking statements including projections, indications or guidance on future earnings or financial position and estimates are provided as a general guide only and should not be relied upon as an indication or guarantee of future performance. There can be no assurance that actual outcomes will not differ materially from these statements. To the full extent permitted by law, Vanguard Investments Australia Ltd (ABN 72 072 881 086 AFSL 227263) and its directors, officers, employees, advisers, agents and intermediaries disclaim any obligation or undertaking to release any updates or revisions to the information to reflect any change in expectations or assumptions.