Thursday, May 21, 2009

Stock Prices : Reverting Towards the Mean

The secular mean of the price-earnings ratio (the Graham ratio) has been around 15 (The graph is posted by Brad De Long on his blog).The implied long term return on investments in stocks in the U.S. has been slightly above 6.5 per cent a year (1/15). The recent free fall of the stock market has brought back the ratio in that neighborhood but not lower than the historical mean. It would thus be rather surprising if that level would constitute a bottom for the next few months: there is still room for further fall if history is to be a guide.

Another interesting interpretation emerges from these past data: bull markets occurred during intense innovation periods. That was the case of the “second industrial revolution” in the two decades preceding 1900, the case also of the generalized diffusion of automobile and electricity in the 1920s, during the post WWII consumers’ equipment boom, and more recently during the communication and information revolution – the IT revolution - starting in the early 1970s.

Stock market crashes following these “exhuberant” episodes probably purge the investment excess of the real economy booms. Since they are relatively far apart from each other, investors forget, or new investors arrive that have not been through such an experience. A new innovation phase is then possible …

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