Extreme equity valuation ratios and stock market investments

Abstract

The extreme valuation ratios for the US equities have led to concerns that the equity market may fall to reflect fundamental values again. This article studies the Vector Error Correction Model (VECM) representation of the price–dividends and price–earnings relationships. The analysis reveals no significant adjustment in prices but significant changes in fundamentals in response to deviations from long-run price-fundamental relationships. This suggests increases in fundamentals but not a falling equity market. Subsequently, the analysis of whether the equity market is overvalued should assess the growth rates of fundamentals inherent in the current valuation ratios. When expected growth rates of dividends and earnings are irrational, then current equity prices are exuberant. The out-of-sample predicted growth rates of the fundamentals are in line with observed historic growth rates. This suggests that equity prices are not exuberant and investing in equities is rational despite the high-valuation ratios.

Notes

¹ See McGowan (2007) for a recent application.

² The inner product of adjustment and cointegration vector must be larger than −2 because the system becomes nonstationary for β′α ≤ −2. The system oscillates toward equilibrium for −2 < β′α < −1. With the two-step cointegration procedure of Engle and Granger (1987), the coefficient for the equilibrium error term has to be negative to enfold the error correction mechanism.

³ The stock market data are available at Robert Shiller's homepage at www.econ.yale.edu/∼shiller

⁴ A zero adjustment coefficient for the equity price is imposed in the VECMs.