In recent years, the US stock market’s extreme mood swings have intensified uncertainty and caused many executives to put off strategic decisions. While no one can forecast the performance of markets with certainty, an analysis based on the real economy’s long-term performance and its links to financial markets yields insights. This vantage point lends some assurance that current valuations are broadly in line with long-term economic fundamentals.
We developed a model to calculate where P/E ratios for the stock market since 1962 would have stood had they been based on long-term corporate profits and growth estimates.11.The stability of long-term profit growth (using GDP as a proxy) and of the cost of equity (around 7 percent in inflation-adjusted terms since 1960, save for a few recessions and financial crises) let us use historical trends to estimate long-term parameters. Our model converts corporate profits to cash flows, using expected returns on capital to drive investment rates. It then discounts these expected cash flows to estimate P/Es. We then matched these basic values to the actual market P/Es. The fit was very close, indicating that, in general, the market values stocks rationally. Only rarely did the measures diverge widely, most notably during the bubble of the ’90s. Actual and fundamental market P/Es have since converged again at around 15, their long-term norm.
P/E ratio for US stock market
