The technology bubble on the US and European stock markets reached its high in March 2000. The peak was followed by a three year bearish trend, during which many investors suffered heavy losses. The investors started to question, whether it was not possible to recognize the bubble on the equity market in advance. Investment strategists and academicians started to come up with new models which were able to indicate time periods when the stock market was over- or undervalued.
Most of these sophisticated models are hidden in the information databases of the investment banks. During the past three years I got an access to most of the databases, which brought me to the decision to write my dissertation about the stock market valuation models.
The aim of this dissertation is to present, construct, evaluate and logically sort contemporary stock market valuation methods. This research paper is divided into three parts.
Part one answers important questions which the stock market valuation methods evoke. Firstly, it describes how the methods define the under- or overvaluation of the market. Then I come up with the definition and anatomy of the stock market bubble. The impact of the equity market bubbles on the economy and its implications for monetary policy are also analyzed in great detail. Part one contains few paragraphs, where I discuss the relationship between the efficient market theory and the stock market valuation models, because these two concepts seem to be in contradiction. Final chapter of part one is dedicated to the index S&P 500. Data related to this index are the main inputs for majority of the presented models.
In part two I presented in detail 19 stock market valuation methods. I sorted these methods into six groups:▪ models based on accounting entries,▪ models analyzing the earnings yield and the bond yield,▪ equity risk premium models,▪ return vs. risk models, ▪ technical methods and▪ psychological methods.
For each model I gathered long-term data, constructed the valuation indicator and at the end of each model I made a summary, which amongst other things includes positives and negatives of the particular method.
Part three is a synthesis of outputs of the 19 stock market valuation models presented in part two. I aggregated results of the models into a unique graphical table. Columns represent each model, lines represent months. Orange color indicates months with high overvaluation and blue color indicates months with high undervaluation.
I went one step further and I constructed my Composite Stock Market Valuation Indicator, which is basically equally weighted index of the modified individual valuation indicators presented in part two.
The Composite Sock Market Valuation Indicator identified many time periods, which had been ex-post recognized by the economists as times, when the stock market was heavily under- or overvalued. Stock market valuation methods are clearly a useful and functional tool for investors, economists and monetary authorities.