Right now one can earn 7.9% on corporate junk bonds(JNK), what kind of PE ratio one would have happy to pay if he wanted to be compensated with a bigger return in order to take equity market risk? A bigger return like, lets say 10%?
Assuming NGDP grows at a 4% rate into infinity(This is actually bellow the avg) and a 1:1 correlation between NGDP and corporate profit growth(Which historically is roughly correct), one should be pretty happy to buy US stocks at a 16.3 PE ratio, or a 5.78% earnings yield
Currently US stocks are bellow this(13 PE according to yahoo). Truth is, with a long-time horizon equities are still the best investment. The shiller PE is 20 but there are some issues with that PE as a result of the financial crisis, it probably overstates the PE a bit(Some individual stocks announced huge losses that distort the PE, I believe AIG falls in that category)
The only way this calculation(For those curious, I arrived at this number through the Dividend Valuation Model from Myron Gordon but used earnings instead of dividends) can be wrecked is if there is massive failure by the Fed and they don't hold NGDP at 4%(Like in the 30's when it turned negative) but I don't think that is a good assumption to make given their defacto inflation target forces the Fed to go all-in everytime inflation is too close to 0%
This doesn't mean stocks are a good investment in the next 5 years however. I believe there will be some profit margin mean reversion that might affect the NGDP and profit growth correlation temporarily but I thought it was interesting that there IS some truth to the permabull CNBCs fund managers when they say 'interest rates are low, these PE ratios make sense'
Assuming NGDP grows at a 4% rate into infinity(This is actually bellow the avg) and a 1:1 correlation between NGDP and corporate profit growth(Which historically is roughly correct), one should be pretty happy to buy US stocks at a 16.3 PE ratio, or a 5.78% earnings yield
Currently US stocks are bellow this(13 PE according to yahoo). Truth is, with a long-time horizon equities are still the best investment. The shiller PE is 20 but there are some issues with that PE as a result of the financial crisis, it probably overstates the PE a bit(Some individual stocks announced huge losses that distort the PE, I believe AIG falls in that category)
The only way this calculation(For those curious, I arrived at this number through the Dividend Valuation Model from Myron Gordon but used earnings instead of dividends) can be wrecked is if there is massive failure by the Fed and they don't hold NGDP at 4%(Like in the 30's when it turned negative) but I don't think that is a good assumption to make given their defacto inflation target forces the Fed to go all-in everytime inflation is too close to 0%
This doesn't mean stocks are a good investment in the next 5 years however. I believe there will be some profit margin mean reversion that might affect the NGDP and profit growth correlation temporarily but I thought it was interesting that there IS some truth to the permabull CNBCs fund managers when they say 'interest rates are low, these PE ratios make sense'
