Are Stock Prices Too High

For equity market investors, this is a perennial question. Since early last December, Fed Chairman Alan Greenspan has also weighed in publicly on this issue, implying that the gain in equity prices over the past year has begun to outstrip the underlying profit fundamentals of corporate America. A careful analysis of equity price behavior offers some support to the Fed Chairman's concern. Rising earnings expectations appear to have played an important role in the equity price gains of the past several months. But now, rising wages, a rising dollar, and current Federal Reserve efforts to contain demand growth and inflation, are all conspiring to cool earnings growth. What has attracted notice is the sheer speed of the equity markets' ascent. Even against their generally healthy performance since the early 1980s, stock price gains of the past two years stand out (Chart 1). The S&P 500 index of stock prices--along with the DowJones Industrials--vaulted record level after record level in quick succession, posting a cumulative gain of over 75% since the end of 1994. But just the fact that equity prices are rising rapidly is not sufficient to cause worries over speculative bubbles. It is important to note that equity prices are affected not only by current earnings and current inflation but also (perhaps more importantly) by expected earnings and expected inflation. All other things being equal, higher expected earnings will lead to higher equity prices. Similarly, lower expected inflation, by lowering the discount factor applied to future earnings, will lead to higher equity prices. A quick look at Chart 1 reveals a relationship that will surprise no one: Earnings performance and stock prices are closely correlated. Corporate profits, provided in the GDP data adjusted for inventory valuation changes and depreciation, approximate closely the level of the S&P index. The chart suggests that, at least through most of 1996, there was no material overvaluation in the level of equity prices. A finer delineation of where equity prices stand is seen in the relative price of equities, i.e., the ratio of the S&P 500 index to corporate profits (Chart 2). This ratio fluctuated in the range of 1.0 to 1.2 in the low-inflation 1960s, fell to the range of 0.6 to 0.8 in the high-inflation 1970s, and has climbed back to the 0.8 to 1.0 range since the early 1980s as the upward path of inflation was reversed. Because inflation and inflation expectations have powerful effects on the valuation of equities, it is interesting to see how the relative price of equities behaves in relation to the ten-year Treasury note yield (same chart). …