Volatility and Valuation

Abstract

The author starts with the relationship between volatility and valuations. In particular, he first addresses the adequacy of the equity market capitalization to GDP ratio, a measure which has recently been used by many observers to suggest that stocks were substantially overvalued. He discusses the relationship between valuation levels and two broad variables: inflation and tax rates, and suggests that valuation levels should therefore fluctuate because the two underlying variables fluctuate as well. Digging into the topic further, the author seeks an alternative metric and suggests that GDP growth seems to be a good long-run approximation for sustainable earnings, though there will be predictable shorter-term divergences, particularly at inflection points or times when policy changes. Further, looking at earnings growth during the last several quarters, he argues that one can begin to understand why the equity market rose faster than earnings, resulting in an expansion of valuation ratios, be they price to earnings or market-capitalization to GDP. Bringing this to a model, he suggests that fluctuations in the rate of economic growth and the change in bond yields do a fairly nice job of explaining and potentially predicting valuation changes.