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Strategies & Market Trends : Zeev's Turnips - No Politics
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To: TREND1 who wrote (72444)5/29/2002 11:37:47 AM
From: Crimson Ghost  Read Replies (1) of 99280
 
Larry:

More from the Fed on stock valuations. A new model shows the S&P 500 still 20% overvalued.

From the KING REPORT

Crudele notes a SF Fed report (FRBSF.org) by Sr. economist Kevin Lansing that states, “…throughout history, occurrences of
major speculative bubbles have generally coincided with the emergence of some superficially plausible "new era" theory. Even with
a pickup in trend productivity growth, investors may have overreacted by heedlessly extrapolating the temporary surge in earnings
growth of the late 1990s far into the future. Some recent studies provide support for this idea. Chan, et al. (2001) show that equity
analysts' forecasts of long-term earnings growth rates have been consistently too optimistic and have exhibited low predictive
power for the actual earnings growth rates subsequently achieved.”

Lansing notes that a better model for stock valuations relates not only the 20-year bond yield to expected earnings, but also adjusts
valuations for the previous 20-years volatility. “Given a current 20-year government bond yield of about 5.5% and employing the
end-of-sample volatility measures for stocks and bonds, the model predicts a P/E ratio of 24.1. Applying this multiple to the
S&P's estimate of $36.34 for reported earnings in 2002 yields a predicted value of 876 for the index--about 20% below the current
level. Fitted P/E ratio from the model captures 70% of the variance in the observed P/E ratio over the sample period 1946 to 2001
(monthly data from 1926-1945 are used to compute the initial volatility measures). In contrast, the inverse bond yield alone does a
poor job of capturing movements in the observed P/E ratio. These results confirm Asness's finding of a strong empirical link
between valuation ratios and the return volatilities experienced by investors.” Conclusion: “Over the long history of the stock
market, high P/E ratios have been transitory phenomena. Campbell and Shiller (2001) show that, sooner or later, the P/E ratio has
tended to adjust back towards its long-run average. These adjustments have taken place mainly through changes in stock prices (P)
rather than through changes in earnings (E)…the model predicts a downward adjustment in stock prices.”
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