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Chapter 2. Evaluating Risk > Market Valuation

Market Valuation

Several studies show a relationship between market risk and the difference between the market's valuation and prevailing interest rates. It's an inverse relationship, meaning low prevailing interest rates support higher market valuations. The S&P 500 Index is usually used as a proxy for the entire market, and most experts express the market's valuation in terms of the S&P 500's price to earnings (P/E) ratio. This P/E ratio is simply the market-weighted average P/E of the stocks making up the index. Market-weighted means the bigger the firm in terms of market-capitalization, the more weight given to its P/E in the calculation.

One way to determine where we are in terms of valuation is to invert the market's P/E to get earnings yield. For instance, the yield is 5 percent if the P/E is 20 (1/20 = 0.05 or 5%). Then compare the market yield to prevailing interest rates, typically the three-month U.S. Treasury bill rate.


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