A long-term, structural devaluation in equities

Markets fell to new lows yesterday and the Price Earnings Ratio (PER) on the FTSE 100 Index is now just 7x earnings.

Clarification: this means that, in order to buy the Index, you will have to pay seven times annual earnings per share on the index.

In context: at the end of 1999, at the market's then peak, you had to pay around 30x earnings to buy the index. Over the longer term the average PER has been around 12-15x earnings.

Meaning? This is the end game in a structural devaluation of equities from excessive values at the end of the last century. Equities are now almost as undervalued today as they were overvalued in 1999. True, there may be further falls and valuations may remain low for longer than expected in order to bring about a reversion to the long-term mean, but the cycle will turn, and valuations will recover.

Equity returns come from dividends, economic growth (inflation) and valuation changes. Of these three components of equity returns, valuations have by far the greatest impact on returns.

In a perfect market where every investor had full information about investments and a rational approach to risk, there would be no valuation gains or losses, and this leads many to argue that the only true returns from equities are dividends and inflationary growth. The reality is that investors are driven by fear and greed and changing attitudes to risk, leading to significant swings in valuations. Rational investors, such as institutions, will see current valuations as an outstanding buying opportunity.

Jeremy