Must-Read: Antonio Fatas: The Stock Market Looks Cheap

Must-Read: Antonio Fatas: The Stock Market Looks Cheap: “I constructed the difference between RF – E/P…

…by using price-to-earnings ratio and 10 year nominal interest rate from Shiller. And I converted nominal into real interest rates using forecasts of inflation from the survey of professional forecasters posted at the Philadelphia Fed…. This is what the stock market “bubble” index looks like…. This chart tells a very different story from the unadjusted P/E ratio. The 90s bubble is still there…. We can also see that the financial crisis of 2008 sent stock prices close to the lowest levels…. Compared to the expansion of the 80s or the 2000s, the stock market today remains “cheap”…. In other words, the stock market tells us that either investors are pessimistic about growth or very risk averse (which is the opposite of what you expect to see during a typical bubble).

Does this mean that the stock market is undervalued? No…. [But] unlike the strong warning signals we get when looking at record-level nominal stock prices or even at the P/E ratio, a simple adjustment of P/E ratios by current levels of interest rates… tell[s] us that the stock market today is on the cheap side relative to previous similar phases of the business cycle.