the equity premium, the higher will be the valuation of stocks relative to
economic fundamentals, such as earnings and dividends. In this more
stable economic environment, firms may wish to boost their earnings by
increasing their leverage, using lower-cost debt to substitute for higher-
cost equity.^19
New Justified P-E Ratios
What do all these favorable developments mean for the stock market?
First, they mean that the average historical P-E ratio of 15 may no
132 PART 2 Valuation, Style Investing, and Global Markets
FIGURE 8–2
Monthly Percentage Change in Industrial Production, 1884 through December 2006(^19) Lower economic volatility also means that labor income has become more predictable and work-
ers can be persuaded to put a larger share of their savings in riskier assets such as equities. This is
because workers will not need to accumulate as many fixed-income assets to protect themselves in
case unemployment arises, which will also have a favorable impact on equity prices. See John
Heaton and Deborah Lucas, “Portfolio Choice in the Presence of Background Risk,” Economic Jour-
nal, vol. 110 (January), pp. 1–26.