Stock Markets: Valuation versus Other Assets
Buy when the coloured lines are low, sell when they are high
This strategy shows how cheap or dear shares are compared to the most
important alternative assets for portfolio investors, namely bonds or cash, i.e.
Bond Yield / PE Ratio or Interest Rate / PE Ratio. The former is also known as
the Fed Ratio, owing to its popularity with the previous Chairman of the Federal
Reserve Bank for assessing over-exuberance on Wall Street. Profits are
cyclically-adjusted in order to smooth out economic swings.
The stock market index is shown in as the thick white line on the right hand
axis. The two explanatory variables, the valuation ratios, PE / Interest Rate,
the yellow line, and PE / Bond Yield, the light green line, use the left hand
axis. Best Guesses for future development of the valuation ratios are also shown
on the left hand axis, respectively in orange and pink. For comparability, stock
market indices have been rebased to set year-end 1994 at 100.
Best Guesses suggest what would happen to the valuation ratios based on
Consensus Forecasts for interest rates and bond yields as well as our own
top-down forecasts for company profits. (See
Earnings Per Share)
Please note that comparisons between countries are of limited value owing to
differences in the reporting of corporate profits. In general these ratios
should be lower where there is a tradition of profit maximisation, as in
Anglo-Saxon countries, than in other countries where the interests of outside
shareholders may take second place to tax minimisation.
Where European currencies have been converted into Euros, the legacy data of the
individual countries have been used as the basis for historic data and converted
into Euros at the fixed exchange rates at the time of unification. Thus, for
example, Deutsche Mark bonds are used for Germany and French Franc bonds are
used for France up to year-end 1998, but both are now based on a common set of
bonds denominated in Euros. EPS continue to be based on companies domiciled in
each country.
For many years, these valuation ratios swung between fairly well-defined highs
and lows, but since the 2008 financial crisis, stock market valuations have
fallen to record lows for this RouteMap. Very long term data for the US suggests
that such valuation levels were last seen in the Fifties.