Under/Over-Valuation of the Stock Market and Cyclically Adjusted Earnings

Abstract

The ratio between current earnings per share and share price (the EP ratio) is widely considered to be an effective gauge of under/over-valuation of a corporation’s stock. Arguably, a more reliable indicator (the cyclically-adjusted EP ratio) can be obtained by replacing current earnings with a measure of ‘permanent earnings’, i.e. the profits that the corporation is able to earn, on average, over the medium to long run. I propose a state-space model to filter business-cycle oscillations out of current earnings and compute the cyclically-adjusted EP ratio. I estimate the model with euro-area aggregate stock market data. I find periods, notably around the 2008 financial crisis, when the adjusted and the unadjusted EP ratios provide economically and statistically different indications. I propose a method to make the adjusted EP ratio easier to interpret by translating its values into estimates of the probability that the stock market is under/over-valued. These estimates clearly indicate periods of mis-valuation in my sample. Furthermore, some simulations suggest that the model would have been able to provide early warning signs of mis-valuation in real time.