Are today's equities overvalued?

The stock market's recent performance is often attributed to the unconventional monetary policies that many central banks have been pursuing. These policies, by design, lowered the return on sovereign bonds, forcing investors to seek yield in markets for higher-risk assets like equities, lower-rated bonds and foreign securities.

According to the standard formulation, stock prices tend to revert toward the present value of estimated future earnings (including growth in those earnings), discounted at the so-called "risk-free rate", augmented by an equity risk premium. More precisely, the forward earnings yield - that is, the inverse of the price-to-earnings (P/E) ratio - is equal to the risk-free rate plus the equity premium, minus the growth rate of earnings.

Monetary policy may have bolstered stock prices in two ways, either lowering the discount rate by compressing the equity risk premium, or simply reducing risk-free rates for long enough to raise the present value of stocks. In either case, equity prices should level off at some point, allowing earnings to catch up, or even correct downward.