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Is Morningstar dishonest? I just read that they show the market as being 3% undervalued. I don’t know how they could possibility reach that conclusion unless it was to sell their products.

Not dishonest, just an opinion. Different opinions make markets. M* fair prices seem to follow after the market price (market price goes up then the fair price goes up), maybe M* is hedging the efficient-market hypothesis (EMH) by incorporating the market price into their fair price estimate. (Many economists reject the "Strong Form" of EMH while still debating the "Weak" and "Semi-Strong" forms, based on research showing insiders generally outperform the market.)

There are mutual funds that use M* fair prices, for example VanEck Morningstar Wide Moat ETF MOAT. MOAT 10-year return of 15.3% is in the top quartile of mutual funds. Unfortunately, MOAT was not around in 2008 when the EMH was tested. Most of the "10 Solid Wide-Moat Funds" listed in 2018 had negative alpha.

M* is now saying NKE is underpriced:
$67.47 NKE market price close 12/12/2025
$104 M* fair value
$88.55 gurufocus Gvalue
https://www.gurufocus.com/stock/NKE/summary?search...

=== links ===

10 Solid Wide-Moat Funds, Sep 19, 2018
Here are the 10 mutual funds with the highest average moat ratings as of their latest portfolios. POLIX LSGRX MPGFX JENIX DGAGX YACKX YAFFX VDIGX AMANX MIGFX
https://www.morningstar.com/stocks/10-solid-wide-m...

Factor regression results from Sep 2018 to Aug 2025 (from portfoliovisualizer):

Ticker  Rm-Rf   SMB    HML    MOM   Alpha                 Name
POLIX   1.02   -0.18  -0.34  -0.10  -0.25%     Polen Growth Institutional
JENIX   0.87   -0.27  -0.02  -0.01  -0.19%      Jensen Quality Growth I
DGAGX   0.97   -0.31  -0.04  -0.02  -0.18%  BNY Mellon Appreciation Investor
VDIGX   0.80   -0.25  0.16   0.07   -0.14%    Vanguard Dividend Growth Inv
AMANX   0.83   -0.23  0.06   0.05   -0.14%        Amana Income Investor
MIGFX   0.96   -0.24  -0.07  -0.04  -0.06%   MFS Massachusetts Inv Gr Stk A
MPGFX   0.93   -0.04  0.00   -0.04  -0.04%         Mairs&Power Growth
YAFFX   0.72   -0.04  0.26   -0.09  -0.04%       AMG Yacktman Focused N
YACKX   0.71   -0.03  0.29   -0.07  0.00%            AMG Yacktman I
LSGRX   1.01   -0.15  -0.33  -0.14  0.20%        Loomis Sayles Growth Y
 
VFINX   0.98   -0.15  0.01   -0.01  -0.01%    Vanguard 500 Index Investor
FCNTX   1.04   -0.20  -0.23  0.04   0.08%         Fidelity Contrafund

Author: huddaman
Subject: Re: OT: Morningstar
Date: 3/25/2020
"Morningstar created an index called "Morningstar Wide Moat Focus Total Return Index". This index uses star ratings (actually they use market value /fair value estimate) to add remove stocks into this index every quarter. ... MOAT that tracks the above index. ... Basically, what I am suggesting is, dont bet the farm on single pick from M* even if it has a market value/fairvalue ratio of 0.25 (CLB currently). Unless you are feeling lucky!"
https://yorickm.com/Message.php?pid=34450726

Efficient-market hypothesis
"The 2008 financial crisis led to renewed scrutiny and criticism of the hypothesis. Market strategist Jeremy Grantham said the EMH was responsible for the 2008 financial crisis, claiming that belief in the hypothesis caused financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking". Financial journalist Roger Lowenstein said "The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis." Former Federal Reserve chairman Paul Volcker said "It should be clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations, market efficiencies, and the techniques of modern finance." In a 2009 article published on the Financial Analysts Journal, Laurence B. Siegel wrote that "By 2007–2009, you had to be a fanatic to believe in the literal truth of the EMH.""
https://en.wikipedia.org/wiki/Efficient-market_hyp...

Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013
"In the 1960s, Eugene Fama demonstrated that stock price movements are impossible to predict in the short-term and that new information affects prices almost immediately, which means that the market is efficient."
https://www.nobelprize.org/prizes/economic-science...

"Since 1872, the S&P 500’s annual starting PE (using trailing 12-month earnings) and forward 1-year returns have an R-squared of 0.01—essentially no causality! R-squared using three- and five-year returns is 0.03 and 0.02. That means just 3% and 2% of US stocks’ forward three- and five-year returns, respectively, even possibly stem from PEs," wrote Fisher. "Randomness. Believing the reverse is just dumbness."

R-squared is a measure of the degree to which one thing determines another. A reading of zero means "A never causes B, while 1.00 signals A always causes B," says Fisher.

"Since 1872, the S&P 500’s annual starting PE (using trailing 12-month earnings) and forward 1-year returns have an R-squared of 0.01—essentially no causality! R-squared using three- and five-year returns is 0.03 and 0.02. That means just 3% and 2% of US stocks’ forward three- and five-year returns, respectively, even possibly stem from PEs," wrote Fisher. "Randomness. Believing the reverse is just dumbness."
R-squared is a measure of the degree to which one thing determines another.

Though I don't have any reason to doubt those numbers, I might suggest that R-squared isn't really the right metric to get much insight. Nor trailing one year P/E. Current P/E is indeed a pretty weak predictor of anything. Price to peak-to-date E is much better, and CAPE better still.

As an alternative view, quintiles of CAPE, 1960-2018, and one year forward US stock returns for dates starting in that valuation quintile:

Most expensive 1/5 of the time: 3.1%
Next 1/5: 7.6%
Next 1/5: 7.8%
Next 1/5: 13.1%
Cheapest 1/5 of the time: 18.7%

A one year forward return is itself a bit of a torture test, as valuation is famously a pretty terrible predictor of stock market prices for time frames under around two years. But that table seems to me pretty darned far from "no causality" or "dumbness" if the thinking is about the general notion of valuation levels mattering to stock returns.

Jim

Data from a study by Columbia Threadneedle Investments done with data to end 2019. I think that for their study they used 7-year CAPE rather than the usual 10-year, but it doesn't make much difference.

Yet another reason not to use Fisher. As you politely point out, using a predictability / correlation statistic on a single variable in an inherently noisy and multivariate-dependent, short-term-emotions-driven market to point out it can't predict returns is, for one thing, silly (charitably).

FC

mungofitch wrote (using 7-year CAPE):
As an alternative view, quintiles of CAPE, 1960-2018, and one year forward US stock returns for dates starting in that valuation quintile:
Most expensive 1/5 of the time: 3.1%
Next 1/5: 7.6%
Next 1/5: 7.8%
Next 1/5: 13.1%
Cheapest 1/5 of the time: 18.7%

Something changed around 1991. Comparing earnings yields before and after 1991 is suspect. In 1991, the S&P 500 price increased 26% while earnings dropped.

Year  Earnings Yield  Dividend Yield  S&P 500  Earnings  Dividends  changeP  changeE
1960      5.34%           3.41%        58.11     3.10      1.98
...
1989      6.80%           3.32%       353.40     24.32     11.73
1990      6.58%           3.74%       330.22     22.65     12.35      -7%      -7%
1991      4.58%           3.11%       417.09     19.30     12.97      26%      -15%
1992      4.16%           2.90%       435.71     20.87     12.64      4%       8%
1993      4.25%           2.72%       466.45     26.90     12.69      7%       29%
...

data from S&P Earnings: 1960-Current (raw data from Bloomberg and S&P). https://pages.stern.nyu.edu/~adamodar/New_Home_Pag...

Using Shiller CAPE data, the S&P 500 earnings yield (trailing 1-year) averaged 8.0% from 1871 to 1989, and 4.6% from 1990 to 2025:

From   To   years  Avg    SD
1871  2025   155   7.2%  2.7%
1871  1989   119   8.0%  2.6%
1990  2025    36   4.6%  1.2%

There was an extra Price doubling around 1990:

Real S&P 500:     E     From   To        P     From   To
                                        flat   1870  1880
                 flat   1870  1895
                                      doubled  1880  1900
               doubled  1895  1905
                                        flat   1900  1950
                 flat   1905  1950
 
               doubled  1950  1965    doubled  1950  1985
                 flat   1965  1995    doubled  1985  1995
 
               doubled  1995  2005    doubled  1995  2000
 
               doubled  2005  2025      flat   2000  2012
                                      doubled  2012  2020

The Shiller CAPE data is more consistent over time with an adjustment: double the earnings starting in 1991.

Average CAEY is much lower recently (CAEY is 1/CAPE):

From   To   years  Avg    SD
1871  1989   119   7.7%  3.0%
1990  2025    36   3.9%  1.0%

Average CAEYb is about the same (CAEYb is CAEY with earnings doubled starting in 1991):

From   To   years  Avg    SD
1871  1989   119   7.7%  3.0%
1990  2025    36   7.7%  1.9%

Dividing into 5 buckets based on CAEYb, from 1960 to 2015 the 1-year total subsequent returns (not adjusted for inflation) were similar to what mungofitch posted:

         lizgdal   mungofitch
qCAEYb  1960-2015  1960-2018
  4       18.7%      18.7%
  3       10.1%      13.1%
  2       10.1%       7.8%
  1       10.6%       7.6%
  0       6.5%        3.1%
  avg     11.2%      10.1%

Dividing into 5 buckets based on CAEYb, from 1881.01 to 2025.12 the average subsequent stock returns were:

qCAEYb  Count  AvgCAEYb  Avg10yrStockSR  Avg5yrStockSR  Avg3yrStockSR  Avg1yrStockSR  Avg 10yrExcessSR  Avg 5yrExcessSR  Avg 3yrExcessSR  Avg 1yrExcessSR  StdDev 1yrExcessSR
  0      348     4.9%         2.2%           1.4%           0.6%           0.4%             1.0%             -0.7%            -1.8%            -0.5%               19%
  1      348     6.0%         6.4%           6.8%           6.0%           6.1%             4.2%              3.8%             3.5%             3.5%               16%
  2      348     7.0%         5.6%           7.1%           8.3%           10.7%            3.7%              5.1%             5.6%             7.0%               20%
  3      348     8.5%         8.2%           6.4%           8.1%           9.4%             7.5%              6.7%             8.3%             8.1%               18%
  4      348     12.0%       10.9%           13.1%          12.8%          15.3%            6.8%              9.5%             9.4%            12.3%               22%
                                                                                                                                                           
correl           1.00         0.93           0.91           0.91           0.90             0.81              0.93             0.87             0.95       

Avg10yrStockSR is the average 10-year subsequent real stock total return (adjusted for inflation).

Avg 1yrExcessSR is the average 1-year subsequent real stock total return minus the real 1-year total return of 10-year bonds.

correl is the correlation with AvgCAEYb.


Low CAEYb had lower forward 1-year excess returns. The dates with low CAEYb (qCAEYb=0) can be summarized as:

  From     To     numMonths  Avg1yrExcessSR  StDev1yrExcessSR
1881.01  1906.11     120           1%              16%
1927.11  1937.08      56          -10%             33%
1955.07  1973.02     134           2%              12%
1987.08  1987.08      1           -22%
1997.07  2000.1       36           -1%             20%

High CAEYb had higher forward 1-year excess returns. The dates with high CAEYb (qCAEYb=4)can be summarized as:

  From     To     numMonths  Avg1yrExcessSR  StDev1yrExcessSR
1907.11  1907.11      1            45%
1914.08  1926.05     113           9%              17%
1931.12  1935.03      18           46%             49%
1941.12  1943.01      14           34%             13%
1948.01  1950.07      19           22%             11%
1974.07  1985.1      114           6%              15%
2002.09  2003.04      8            24%              7%
2008.03  2013.06      61           10%             22%

If I am interpreting your work correctly, real 10yr bond returns have been surprisingly poor compared to equities, in all but quintile zero conditions. (Not sure why "surprisingly," but I try to be cautious with any data that confirms my own prejudices...

Very interesting stuff.

Baltassar

I calculate an average equity premium (1yrExcessSR) of 6.1% using the Shiller CAPE data. This is close to what Wikipedia writes "around 5% to 8% in the United States".

                avg
   AvgCAEYb     7.7%
 
Avg10yrStockSR  6.7%
Avg5yrStockSR   7.0%
Avg3yrStockSR   7.2%
Avg1yrStockSR   8.4%
 
 10yrExcessSR   4.6%
  5yrExcessSR   4.9%
  3yrExcessSR   5.0%
  1yrExcessSR   6.1%

"The equity risk premium is equal to the difference between equity returns and returns from government bonds. It is equal to around 5% to 8% in the United States. The risk premium represents the compensation awarded to the equity holder for taking on a higher risk by investing in equities rather than government bonds. However, the 5% to 8% premium is considered to be an implausibly high difference and the equity premium puzzle refers to the unexplained reasons driving this disparity."
https://en.wikipedia.org/wiki/Equity_premium_puzzl...


Some preliminary actionable signals:

high CAEYb (qCAEYb=4)
expect high Avg1yrStockSR (high 1-year real stock return)
increase stock leverage

low CAEYb (qCAEYb=0)
expect low Avg3yrExcessSR (stock return lower than bond return)
wait 1 year, and then increase bond weight.
(Avg3yrExcessSR is lower than Avg1yrExcessSR, and so the best relative bond returns were in years 2 and 3.)

But averages can hide problems, and so more work is needed on this possible signal.

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