What are Stock Market Valuation Models (SMVMs)? Why are SMVMs important for investment professionals? What is a Composite Valuation Indicator?

1. Stock Market Valuation Models
and
the Composite Valuation Indicator
Karel Tregler, Ph.D.
November 2007

2. Content
I. What are Stock Market Valuation Models (SMVMs)?
II. Why are SMVMs important for investment professionals?
III. What is a Composite Valuation Indicator?
SMVMs and the Composite Valuation Indicator 2

3. I. What are Stock Market Valuation Models?
Stock Market Valuation Models (SMVMs) measure overvaluation or
undervaluation of an equity market relative to its fair value.
During 3 years of extensive research I have identified and analyzed
18 different SMVMs and I have sorted them into the following
groups based on their similarities:
equity risk premium models
models based on earnings yield and bond yields
models based on accounting multiples
models based on technical analysis
models based on psychological analysis
Every model has its own definition of “fair value” of the stock
market or the stock market index.
SMVMs and the Composite Valuation Indicator 3

4. I. What are Stock Market Valuation Models?
The next page shows an example of graphed output from one of
the SMVMs. Such an indicator of over- and undervaluation of the
stock market can be constructed for each of the 18 models.
As we can see, the indicator has identified all the famous bubbles
and crashes since 1979.
Results of the SMVMs can be then synthesized into a graphical table
and into a Composite Valuation Indicator (see chapter III).
SMVMs and the Composite Valuation Indicator 4

5. I. What are Stock Market Valuation Models?
This valuation indicator is based on the well-known Yardeni‘s stock
market valuation model (this model has been used by Deutsche
Bank and by Prudential Financial)
80 1 600
Stock Market Valuation Indicator based on Yardeni's model (left axis) points
%
S&P 500 (right axis)
60 1 400
1987 Bubble 2000 Dot Com Technology Bubble
40 1 200
OVERVALUED
20 1 000
0 800
-20 600
UNDERVALUED Sept. 11, 2001
-40 400
Stagflation,
Oil Crisis LTCM and the
Accounting scandals,
-60 200
Russian Default
Market Capitulation
-80 0
I-79
I-80
I-81
I-82
I-83
I-84
I-85
I-86
I-87
I-88
I-89
I-90
I-91
I-92
I-93
I-94
I-95
I-96
I-97
I-98
I-99
I-00
I-01
I-02
I-03
SMVMs and the Composite Valuation Indicator 5

6. II. Why are SMVMs Important for Investment
Professionals?
SMVMs are an essential part of the Asset Allocation Process (see
next page)
SMVMs are the key quantitative inputs for any strategic asset
allocation decision, i.e. how much will be invested in equities
compared to other asset classes.
SMVMs are used by equity strategists or analysts to estimate
the expected returns or levels of an equity market index
in the future.
Some of the SMVMs are forward looking, so they have an
important predictive ability.
SMVMs and the Composite Valuation Indicator 6

7. II. Why are SMVMs Important for Investment
Professionals?
ASSET ALLOCATION PROCESS:
Is the stock market
Global Macroeconomic Analysis over- or undervalued?
SMVMs are applied.
Strategic Allocation Analysis
Bonds Equities Real Estate Other
Industry Analysis
Company Analysis
SMVMs and the Composite Valuation Indicator 7

8. III. What is a Composite Valuation Indicator?
Results of the 18 SMVMs can be synthesized into a unique
graphical table and into a Composite Valuation Indicator
The graphical table on page 9 is constructed in the following
way: columns represent models, lines represent months.
Orange indicates months with the highest overvaluation and
blue indicates months with the largest undervaluation.
LEGEND:
Highly overvalued market
Highly undervalued market
Market is close to its fair value
Data not available
The Dot Com Technology Bubble can be seen immediately
Names of all 18 models are listed in Appendix II
SMVMs and the Composite Valuation Indicator 8

9. MODEL NUMBER (Names of all 18 models can be found in the Appendix II)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
YEAR
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
SMVMs and the Composite Valuation Indicator
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
III. What is a Composite Valuation Indicator?
2002 ;
2003
2004
9

10. III. What is a Composite Valuation Indicator?
A Composite Valuation Indicator is my synthesis of
outputs of the 18 stock market valuation models (page 11).
It is basically an equally weighted index of the individual
valuation indicators.
The Composite Valuation Indicator identifies several time
periods, which had been recognized by economists ex-post as
times when the stock market was heavily under- or
overvalued.
The Composite Valuation Indicator clearly identified
the major market bubbles and crashes of the past 100
years (see next page).
SMVMs and the Composite Valuation Indicator 10

11. III. What is a Composite Valuation Indicator?
The Composite Valuation Indicator measures by how much
and when the stock market was over- or undervalued
%
140
2000 Dot Com Technology Bubble
120
1929 Buble
100 Nifty Fifty Bubble
80 Copper Mines Craze 1987 Bubble
OVERVALUED
60
40
20
0
-20
-40
UNDERVALUED
-60
War in Korea
1907 Crash
-80
1903 Crash Stagflation,
Oil Crisis
-100
1st World War OPEC
-120 Post-war
Fed Increases Embargo
Financial Crisis, Beginning Recession
the Minimum 2nd World
-140
of the Great Depression Reserves, 1937 1969-1970 Crash
War
-160
1900
1905
1910
1915
1920
1925
1930
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
SMVMs and the Composite Valuation Indicator 11

12. Appendix I
Karel Tregler, Ph.D.
Graduate of the Prague School of Economics
Doctorate received in 2004
Currently employed as an Equity Portfolio Manager at PPF Asset
Management in Prague
PPF Asset Management has approx. 7 bn. USD under management
Detailed analysis and subsequent synthesis of the SMVMs was first
presented in my dissertation in November 2004
A few months later the dissertation was published by C.H. Beck
publishing (www.chbeck.cz)
Contact details:
email: tregler@ppf.cz
SMVMs and the Composite Valuation Indicator 12

13. Appendix II
Names of the 18 Stock Market Valuation Models
1. Dividend Yield Model
2. Expected Risk Premium Model à la Dresdner Kleinwort Wasserstein (since 1874)
3. Graham & Dodd P/E Model
4. Current P/E Model
5. Tobin‘s Q Model
6. Asness Model
7. E-STAR Model
8. Historical Risk Premium Model
9. Yardeni‘s Fed Model (SVM 1)
10. Normalized Fed Model a la Dresdner Kleinwort Wasserstein
11. Cumulated Market Returns Ratio
12. Expected Risk Premium Model à la Dresdner Kleinwort Wasserstein (since 1980)
13. PEG Model
14. Forward P/E Model
15. Yardeni‘s SVM 2 Model
16. Three Stage Expected Risk Premium Model a la Société Générale
17. Valuation Confidence Index Model
18. Implied Volatility Model
SMVMs and the Composite Valuation Indicator 13