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August 2011

Toss out the old valuation metrics

These days it's hard to take your eyes off the volatile markets.  One metric that investment gurus use to argue whether the market is overvalued or undervalued is the P/E ratio.  There is a group of people who prefer to use Bob Shiller's 10-year PE to smooth out the noises of business cycles.  But none of these took into consideration of the demographic change the US is facing in coming decades when "baby boomers", born between 1946-1964, reach their retirement age, i.e., between 2011-2029.

Should we expect the same valuation as in previous decades?   The recent research from San Francisco Fed. offers us some insights:

To examine the historical relationship between demographic trends and stock prices, we consider a statistical model in which the equity price/earnings (P/E) ratio depends on a measure of age distribution (for another example, see Geanakoplos et al. 2004). We construct the P/E ratio based on the year-end level of the Standard & Poor’s 500 Index adjusted for inflation and average inflation-adjusted earnings over the past 12 months. We measure age distribution using the ratio of the middle-age cohort, age 40–49, to the old-age cohort, age 60–69. We call this the M/O ratio. 

Figure 1 displays the P/E and M/O ratios from 1954 to 2010. The two series appear to be highly correlated.


Figure 2 compares the actual and model-implied P/E ratios for the sample period ending in 2010. We calculate the path for the model-implied P/E during the sample period by feeding in actual M/O ratios. We call the long-run path of the P/E ratio predicted by the model the “potential P/E ratio” and designate it P/E*. Figure 2 shows that the P/E* (red dashed line) is highly correlated with actual P/E during the sample period.