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An Objective Approach to Relative Valuation

Ruben D. Cohen

Abstract

A fundamental approach to describing the behaviour of the equity price index is presented. The method centres on the contention that, under a constant discount rate and in a market that is efficient and in equilibrium, the forward-looking risk premium is equivalent to the expected dividend yield, and both are equal to zero. Extending this special-case scenario to one that involves time-wise variations in the discount rate leads to a special co-ordinate transformation [or mapping], which addresses how the index should behave correspondingly.

Applying the same principle to both, corporate earnings and the nominal gross domestic product [GDP], leads to a similar transformation. This, consequently, makes way for objective comparisons between the equity index, corporate earnings and the GDP, thereby raising the notion of relative valuation in this context. A practical demonstration of this is ultimately provided for the US and UK economies and equity markets.

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