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Under/over-valuation of the stock market and cyclically adjusted earnings

Listed author(s):
  • Marco Taboga


    (Bank of Italy)

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.

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Paper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 780.

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Date of creation: Dec 2010
Handle: RePEc:bdi:wptemi:td_780_10
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  1. van Norden, Simon, 1996. "Regime Switching as a Test for Exchange Rate Bubbles," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 11(3), pages 219-251, May-June.
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