Thursday, December 4, 2008

The Graham Ratio Indicates the Market Does Not Suffer From Irrational Pessimism

Christopher D. Carroll in "Recent Stock Declines: Panic or the Purge of “Irrational Exuberance”? The Economists Voice, Vol. 5 (2008) presents new data on the Graham Ratio. As originally proposed by Benjamin Graham it is the ratio of stock prices to a 10-year average of lagged earnings. Carroll revises the ratio for a 12-year average of lagged earnings in order to more closely follow the political cycle. As indicated in the above diagram from the article, high values of the Graham ratio have signalled lower subsequent returns over the next 12 years. The current Graham ratio is about right in the center of the data plot indicating neither irrational exuberance or pessimism.

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