Shares RouteMap: Valuation versus Other Assets

Buy when the coloured lines are low, sell when they are high

sample chart showing valuation oscillators - PE / bond yield is green. Y/Y forecasts are mauve. PE / interest rate is yellow. Y/Y forecasts are orange.

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.