ECB says a correction is likely whether or not today's prices are rational

Five economists at the European Central Bank published an analysis on Monday arguing that stock market valuations are likely to correct, and that the argument holds whether or not today’s prices are rational.

The post, by Malin Andersson, Johannes Breckenfelder, Stefano Corradin, Kalin Nikolov and Maria Antonietta Viola, puts US valuations close to their historical peak on the CAPE ratio, a measure comparing share prices against inflation-adjusted earnings averaged over the preceding decade.

Euro-area valuations have risen as well, by less. Research on past technological revolutions, the economists write, points to “a worrisome conclusion.”

The views are the authors’ own and do not necessarily represent the ECB.

Rational valuations and investor exuberance point to the same outcome

This post gives both the rational and behavioural explanation. According to the rational explanation, extreme uncertainty with regard to a new technology’s efficiency would be enough to justify the valuation of its stocks at very high levels since one loses nothing much by trying it out and there is no way to tell the limit on the upside. This asymmetry creates an option value which increases price-to-earnings ratios for early adopters.

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