Excerpt from The Economist Jan 7th 2010:
A better long-term measure is the cyclically adjusted price-earnings ratio, which averages profits over the previous ten years (see chart 2). On this measure, valuations are nowhere near the 2000 peak. They are, however, still pretty high by historical standards; Smithers & Co, a firm of consultants, reckons they are nearly 50% above their long-term average. Even now, after a dismal decade for shares, Wall Street is offering a dividend yield of only just over 2%, compared with a long-term average of 4.5%.
In housing, a measure based on rents shows that American prices are back to fair value but prices in Britain, France, Spain and Australia are all 30-50% above their historic averages. Low mortgage rates (and government schemes to head off foreclosures) have stopped prices falling to the lows of previous downturns.
That said, although prices remain higher than average, private investors have shown little of the enthusiasm they exhibited in past bubbles. Activity in the housing market is subdued. Investors withdrew $36 billion from developed-market equity funds in the course of 2009, according to EPFR Global, a data group.
The markets are beset by a series of contradictions. They are dependent on extraordinary amounts of government stimulus. But that stimulus is in turn ultimately dependent on the willingness of markets to finance governments at low rates. They should be willing to do so only if they believe that growth prospects are poor and inflation will stay low. But if they believe that, investors should be unwilling to buy equities and houses at above-average valuations. At some timeâ€”maybe in 2010â€”those contradictions will have to be resolved. And that will trigger another nasty bout of volatility.