Can equity price movements be better explained when taking interest rates directly into account?
News, Staff memo Equity valuation metrics, such as the cyclically adjusted P/E (CAPE) ratio, can help explain subsequent stock price movements in Sweden. This is one of the conclusions in a new staff memo where the authors evaluate the explanatory power of two different valuation metrics, one which indirectly takes the level of interest rates into account and one which explicitly does so. The authors argue that the CAPE ratio carries important information about the valuation of the Swedish stock market, thus being a relevant gauge of risks of future equity price declines and valuable tool in the financial stability analysis.
The equity market is an important part of the financial system, both from the perspectives of investors and the companies that need financing in the form of equity capital. Developments in equity markets can therefore provide valuable information on the state of the financial system and the economy as a whole. This also means that downturns in equity prices could have consequences for financial stability. Strong price developments in equity markets worldwide in recent years have brought equity valuations as a recurring topic of discussion. One area of debate has been to what extent the low interest rates have contributed to higher equity prices, and what might happen when interest rates begin to rise again.
In this staff memo, the authors study how well historical equity market valuations, captured in the form of the CAPE ratio, have been able to explain stock price developments in subsequent time periods. Furthermore, the authors examine whether a measure which explicitly take interest rates into account, the so called Excess CAPE Yield, has better explanatory power.
The empirical analysis is conducted for several countries (Sweden, the United States, Germany and the United Kingdom) and the conclusion is that CAPE works well for all of the countries included in the analysis. In the case of Excess CAPE Yield, the results vary between different stock markets and time periods. In general, Excess CAPE Yield works well for the United States, though not as well for Sweden and other countries.
The Staff Memo has been written by Ana Maria Ceh, Jonatan Manfredini, Ola Melander and Stephan Wollert. The authors work in the Monetary Policy Department and the Financial Stability Department of the Riksbank.
ABOUT THE RIKSBANK’S STAFF MEMOS
Staff Memos are a form of publication from the Riksbank and a complement to other publications, such as Economic Commentaries and Riksbank Studies. A staff memo provides members of the Riksbank’s staff with the opportunity to publish advanced analyses of relevant issues. It is a publication for civil servants that is free of policy conclusions and individual standpoints on current policy issues.