Higher interest rates can be challenging for financial markets – at least to begin with – as reflected in the sharp drop in bond¹ prices over the past two years.

But share prices in the US have continued to hit fresh highs. This suggests investors may be too complacent about expanding valuations (the market’s view of how much company shares are worth).

Here we explore whether investors have reason to be cautious.

Where valuations stand today 

What we think of as a fair value for shares depends in part on the wider economic environment, including interest rates, inflation and market volatility (or fluctuations in prices).

Higher valuations for company shares can be justified during periods of low interest rates, low inflation and low volatility. This is because low rates push down today’s cost of a stake in a company’s future earnings, while higher rates have the opposite effect.

However, US share prices have climbed to new highs even as we have moved to a higher-interest-rate environment. We think US share prices are about 30% above our estimated range for what is ‘fair value’ for those shares². 

For context, US share valuations have rarely been this high. Since 1950, they have only reached this level during the dot-com bubble and the post-Covid reopening.

How the valuation gap could close over time

A fall in interest rates could help to close the valuation gap. However, although we expect interest-rate cuts this year, we don’t expect them to be enough to significantly increase our estimates of what fair value is for US shares.

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 share prices.

What valuations can and can’t tell us

Valuations are a strong indicator of long-term (usually considered beyond five years) returns from shares, and that doesn’t bode well for the US market given where valuations currently sit.

However, while valuations are undoubtedly high right now, that doesn’t mean they can’t go higher in the near term. Even over extended periods, valuations are not a fail-safe predictor of whether markets will go on to over- or underperform. 

That’s why, even with our more guarded outlook for US shares over the next decade, we would not encourage investors to make drastic changes to their investments if they have a balanced portfolio of global shares and bonds.

Diversification is the healthy option

Regardless of the return outlook for US shares, having a mix of assets across global shares and bonds, so that better-performing investments help to offset those that perform less well, can help to smooth out returns over time.

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.
 

¹ Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.

² What Vanguard thinks of as fair value for shares is based on Vanguard’s US fair-value cyclically-adjusted price-earnings (CAPE) ratio. The CAPE ratio, which considers current share prices relative to 10-year inflation-adjusted earnings per share, is a common metric for valuing US shares. Vanguard’s statistical model adjusts the CAPE measure for the level of inflation and interest rates. The statistical model includes equity-earnings yields, 10-year trailing inflation and 10-year US Treasury yields estimated from January 1940 to January 2024. Currently, valuations are above our range of fair-value estimates. Sources: Vanguard calculations, based on data from Robert Shiller’s website, the U.S. Bureau of Labor Statistics, the Federal Reserve Board, Refinitiv, and Global Financial Data.