increase over time as new firms go public. Another misleading time se-
ries is a representative stock index against average housing prices. The
flow of housing services, or rental income, is not included in the price of
homes, while stock price indexes include capital gains caused by rein-
vested earnings.CONCLUSION
The fundamental determinant of stock values remains the earnings of a
corporation, from which dividends are paid, and the interest rate that
discounts those dividends. The best concept of earnings is the “core
earnings” concept developed by Standard & Poor’s in 2002, which was
the first to fully expense options and make adjustments to pension in-
come. The earnings yield, which is the reciprocal of the P-E ratio, is a
good predictor of future realstock returns.
One of the most difficult issues in economics is to know when there
has been a basic structural shift in the economy and when there has not.
Admittedly, there are too many times, such as the technology bubble at
the end of the last century, when speculators used “new era” economics to
justify unreasonably high prices. But there are also times when there has
been an important structural shift, such as in the 1950s when the dividend
yields on stocks fell below the interest rates on long-term Treasury bonds.
There have been some important shifts in recent years. The fall in
the dividend payout ratio has shifted stock returns from dividends to
capital gains, impacting the growth rates of future earnings and divi-
dends. Furthermore, the dramatic fall in transactions costs combined
with the increase in macroeconomic stability may also change the P-E
ratio of stock prices to valuation metrics. How these events will impact
future stock returns will be discussed in the next chapter.CHAPTER 7 Stocks: Sources and Measures of Market Value 121