Explaining international equity valuation ratios: The roles of commodity price inflation and relative asset volatilities

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This article investigates factors that have influenced stock market valuations across a number of international markets. Previous studies have found that factors such as long bond rates and stock and bond volatilities have been able to describe how investors have historically set equity multiples in the United States. We find that these variables do not apply to non-US markets but that the relative rates of input and consumer inflation are important in explaining stock valuations internationally. A positive relationship is observed between the producer price inflation/consumer price inflation (PPI/CPI) ratio and stock yields, which we conjecture reflects investors’ concerns that rising commodity prices will manifest in reduced future profitability for companies and lower returns for equities. We observe that the PPI/CPI ratio is more convincing internationally at explaining equity valuations compared to the stock and bond volatility approach that has proved successful in the United States. Indeed, we also posit that the unprecedented price-earning ratios seen globally around the end of the twentieth century can be attributed in part to the extremely depressed real price of commodities at that time.