Shares: Valuation

Buy when the coloured lines are at the low end of their range, sell when they are high

This tool is intended to show the attractiveness of shares against alternative assets competing for the funds of domestic investors. This is known in the US as the Fed ratio, owing to ist popularity with the Chairman of the Federal Reserve Bank for assessing over-exuberance on Wall Street.

This valuation ratio is designed not only to show the current position but also to provide a best guess as to the future trend. This is useful for spotting extremes of over- or under-valuation.

It does so by comparing the PE ratio against short-term interest rates and also to the yield on long-term bonds, in those countries where there are active bond markets. For comparability, stock market indexes have been rebased to set year-end 1994 at 100.

In each chart the stock market index is shown in as the thick white line on the right hand axis. The main explanatory variables, the two 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 -Best Guess forPE / Interest Rate is the orange line, Best Guess for PE / Bond Yield is the pink line.

Best Guesses suggest what would happen to the valuation ratios based on forecasts for interest rates, bond yields and company profits, assuming share prices remain constant. The base level is the average for the last completed calendar year. Interest rates and bond yields are consensus estimates. Company profits are econometric forecasts by PIT.

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 government bonds and interest rates of the individual countries have been as the basis for historic data. Thus, for example, the long-term Bond ratio for Germany is based on Deutsche Mark bonds up to year end 1998 and that for France is similarly based on French Franc bonds in the past, but both are now based on a common set of bonds denominated in Euros. The PE ratios continue to be based on companies domiciled in for each country.

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