Understanding Equity Valuation Through the Fowler Drew Model

The question of whether equities are overvalued frequently arises in media discussions, often tied to concerns about market corrections. These views are usually based on speculation about fundamental factors, such as price-to-earnings ratios or macroeconomic trends.

At Fowler Drew, our approach to assessing market valuations is different. We rely on an objective, technical model that avoids speculation and narratives. Our model’s data-driven outputs allow us to determine if equities are overvalued relative to historical trends, providing a rational basis for investment decisions.

The Market Context: Are Equities at Risk of a Correction?

Many commentators suggest that markets are overvalued and due for a downturn. These arguments often stem from:

• High price-to-earnings (P/E) ratios.
• Speculation about macroeconomic risks, such as inflation or slowing economic growth.
• Concern over monetary policy, especially the impact of government stimulus.

Rather than relying on subjective views, the Fowler Drew model assesses equity markets using historical return trends and risk-adjusted performance. The chart at the heart of our model provides a clear, quantitative picture of where valuations stand relative to history.

How the Fowler Drew Model Measures Valuation

1. Risk and Return Trade-Off for Equities

The key inputs in our model focus on real investment returns (after inflation) over a defined holding period. The chart generated by our model:

• Plots annualised expected return (y-axis) against risk (x-axis) for different markets.
• Risk is measured as the standard deviation of real returns over the selected period (in this case, 10 years).
• The optimal mix of equity markets is determined based on risk-adjusted return, shown as the red marker on the chart.

This allows us to compare different stock markets objectively, using a risk-adjusted measure of valuation rather than relying on fundamental ratios like P/E.

2. The Role of Bonds in the Model

• The blue marker on the chart represents the risk-free rate, based on Index-Linked Gilts (ILGs).
• Since ILGs provide a real return with zero uncertainty over the holding period, they form the basis of our comparison.
• The Capital Allocation Line (the slope between the blue and red markers) represents the risk premium for equities.

The steepness of this line tells us how much investors are compensated for taking equity risk relative to the risk-free alternative.