A new approach for the
relative valuation of an equity price index is presented. The method is based on a coordinate
transformation or mapping, which enables one to weigh the index against the
aggregated earnings and GDP. This,
therefore, gives rise to the notion of relative valuation between the index,
the earnings and the GDP. A practical
demonstration of this is then provided for the US, UK and Japan economies and
some of their major equity indices, namely the S&P500, FTSE100 and TOPIX,
respectively.
Another potential application of the above
is also discussed, which relates to forecasting the GDP. This stems from the assumption that the
expected GDP, one year ahead from today, is readily priced in today’s interest
rates. The method is further applied to
computing duration. This is shown to
circumvent the difficulties that are generally associated with calculating the
parameter.
