Item of the Week: Charts
April 5, 2006

This chart above and the one below are from Robert Shiller's web site.   What do they tell us?  Most obviously, we see the well understood strong correlation between stock prices and earnings over a long period of time.  We also see that this relationship becomes exaggerated during stock market bubbles, in the 1920s and 1990s.  We also observe the tendency for both earnings and stock prices to "echo" after the collapse of a stock bubble, as they did in the 1930s and are doing again today.  This is probably the result of central bank intervention in interest rates.  The Fed lowered interest rates agressively in both post-bubble periods.

Earnings are higher today than when the stock market was at its peak in 2000.  Does this mean stocks are likely to "catch up" or are they already high by historical measures?  A look at the relationship between the price/earnings ratio and interest rates says stock prices are still high relative to earnings unless interest rates decline.

Stock prices tend to rise when interest rates are falling.  Interest rates are on the rise globally.  We expect they will continue to rise and stocks to decline until the S&P P/E ratio reverts to the mean of around 15.  Timing and trajectory are unknowable, but we suspect that a ten year process starting in 2006 is a fair guess.  That means an S&P at around 800 from the current 1200.  That's the inflation-adjusted price.  The nominal S&P index price may remain, for example, around 1200 for the duration of that period.


Previous Items of the Week:
March 6, 2006: Distribution of Income Gains by Income Bracket
March 22, 2006: Roubini and Others Speak at CATO Conference on
Monetary Institutions and Economic Development

March 25, 2006: Net Foreign Acqusition U.S. Financial Assets

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