earnings. The reason why the Fed model worked is that the market rated
these two risks as approximately equal during this period.
There is no question that both bonds and stocks do badly when in-
flation increases. Bond prices fell in the late 1960s and 1970s because ris-
ing inflation forced interest rates up to offset the depreciating value of
money. Stocks fall during inflationary periods for other reasons, such as
poor monetary policy, low productivity, and a tax system that is only
partially indexed to inflation. These are detailed in Chapter 5.
But these two risks are not equal when inflation is low or when de-
flation threatens. In those circumstances, bonds (especially U.S. govern-
ment bonds) will do very well, but deflation undermines firms’ pricing
power and is bad for corporate profits. Figure 7-4 shows that before in-
flation became a major concern in the 1970s, there was no relation be-
tween bond yields and earnings yields and the Fed model broke down.
In order to put stock and bond valuations on an equivalent valua-
tion, one should compare the earnings yields on stocks with the yields
on Treasury inflation-protected securities (TIPS) and bonds. TIPS have
absolute certainty of purchasing power return and are the safest assets.
Stocks are of course riskier, and they should bear a risk premium above
TIPS.
There is considerable debate on what constitutes a “normal” risk
premium between stocks and inflation-protected bonds, as is discussed
in Chapter 2. Generally the equity risk premium is taken between 2 and
3 percent, but it could certainly be higher in times of great uncertainty or
lower when investors are very bullish on stocks.Corporate Profits and National Income
Another indicator of stock market valuation is the ratio of corporate
profits to national income (GDP). Its rise in recent years has alarmed
some stock market analysts who worry that if the share of profits to na-
tional income falls to its long-term average, stock prices will suffer.
Closer examination of this claim should put those fears to rest.
Figure 7-5 displays the ratio of after-tax corporate profits and after-tax
profits plus proprietors’ income, and their sum since 1947. Proprietors’
income is profits of nonincorporated businesses, including profits to
partnerships and individual owners.
One can see the long-term downtrend of proprietors’ income share
from the 1940s to the 1980s, which has recovered only slightly since then.
Over this period many brokerage houses, investment banks, and other
firms became publicly traded corporations, and some government-CHAPTER 7 Stocks: Sources and Measures of Market Value 115