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There Are Many Stock Market Valuation Models, And Most Of Them Stink

Published by Business Insider on Thu, 04 Dec 2014


Does low inflation justify higher valuation multiples' There are many valuation models for stocks. They mostly don't work very well, or at least not consistently well. Over the years, I've come to conclude that valuation, like beauty, is in the eye of the beholder.For many investors, stocks look increasingly attractive the lower that inflation and interest rates go. However, when they go too low, that suggests that the economy is weak, which wouldn't be good for profits. Widespread deflation would almost certainly be bad for profits. It would also pose a risk to corporations with lots of debt, even if they could refinance it at lower interest rates. Let's review some of the current valuation metrics, which we monitor in ourStock Market Valuation Metrics & Models:(1)Reversion to the mean.On Tuesday, the forward P/E of the S&P 500 was 16.1. That's above its historical average of 13.7 since 1978.(2)Rule of 20.One rule of thumb is that the forward P/E of the S&P 500 should be close to 20 minus the y/y CPI inflation rate. On this basis, the rule's P/E was 18.3 during October.(3)Misery Index.There has been an inverse relationship between the S&P 500's forward P/E and the Misery Index, which is just the sum of the inflation rate and the unemployment rate. The index fell to 7.4% during October. That's the lowest reading since April 2008, and arguably justifies the market's current lofty multiple.(4)Market-cap ratios.The ratio of the S&P 500 market cap to revenues rose to 1.7 during Q3, the highest since Q1-2002. That's identical to the reading for the ratio of the market cap of all US equities to nominal GDP. Today'sMorning Briefing:Inflating Inflation.(1) Dudley expects Fed to hit inflation target next year. (2) It all depends on resource utilization. (3) What if demand-side models are flawed' (4) Supply-side models explain persistence of deflationary pressures. (5) Inflationary expectations falling in TIPS market. (6) Bond market has gone global. (7) Valuation and beauty contests. (8) Rule of 20 says stocks still cheap. (9) Other valuation models find no bargains. (10) Cheaper stocks abroad, but for lots of good reasons. (11) US economy humming along. (More for subscribers.)Join the conversation about this story
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