the deviations of the P/E from its historical average are in fact quite modest. But suppose that we see them as significant, that we believe they indicate the expected return on stocks is unusually low relative to history. Is it low with respect to the expected return on other assets? A central aspect of the crisis has been the decrease in the interest rate on bonds, short and long. According to the yield curve, interest rates are expected to remain quite low for the foreseeable future. The expected return on stocks may be lower than it used to be, but so is the expected return on bonds.
Pointer from Mark Thoma.
Their point is that when interest rates are low, you can justify exceeding historical norms for the price-earnings ratio on stocks. I made a similar point about the price-earnings ratio for real estate relative to interest rates during the housing bubble.
They are explaining why the P/E got high, perhaps not why it will stay high.
If you regress the PE on trailing operating earnings from 1960 to 1995 you get a very good regression with a high R-square and a very low standard error and so forth.
If you apply that PE equation with current interest rates and inflation it says the PE should be around 19, or modestly above the actual PE on trailing operating earnings.
If you update the regression to include the last 20 years you get about the same coefficients on the variables but the R-square is weaker and the standard error is larger.
But maybe the problem is lower earnings. For most of the post-WWII era trend earnings growth was about the same as the growth of nominal GDP.
But if we are now in a lower growth era maybe both nominal GDP and trend EPS growth should be lower. So maybe having a lower PE now on trailing operating EPS just means that investors are starting to discount a lower long term growth rate for EPS and there really no problem with the market being overvalued..
This line of thought is based on the view that the PE is a representation of the present value of the expected future stream of income.