In last week’s Economics Weekly we discussed two measures of equity valuation—the equity Q ratio and the cyclically adjusted P/E ratio (CAPE)—highlighting Andrew Smithers’s point that these two measures of valuation fulfill the criteria of a good valuation metric in that they compare current prices against a stable fundamental (replacement cost of existing capital and average 10-year trailing earnings per share), they both give a very similar reading, and they are both mean reverting series (after all, what use is a valuation metric that doesn’t mean revert?). In this week’s Economics Weekly we continue to discuss these ratios and the current state of U.S. profit margins, specifically with regard to the crucial necessity of mean reversion and investors assumptions about continued growth.
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Richard de Chazal, CFA is a London-based macroeconomist covering the U.S. economy and financial markets.