Not sure if I was the only one who kept missing these questions, but I thought I would share this because I could never get this right wit how others explained it… I think it works all the time…
If the question is asking if the equity market is over / under valued just look at it as (numerator / denominator)
comparing the numerator (equity market = E1/P0) relative to the denominator.
If the numberator has a higher yield it means you want to buy it because it it’s a good deal (undervalued) . If the yield is lower than the denominator why would you want the lower yield? you don’t want stuff that’s overpriced relative to the denominator (10 Yr Bond or Yardini).
What you want to look at is the denominator (for simplicity).
Since equilibrium requires the EY to equal the 10yr bond yield, a low EY (compared to 10 yr by) would have to adjust upwards, meaning a decrease in P, meaning that P is currently overvalued.
your way of thinking is CFAI thinking mine is for the simple minded that use the average joe language haha.
but ya that would be consistent with how we look at interest rate movements.
take the reciprocal ( 1/n )
this is the P/E ratio.
compare to P/E ratio of the market (1/Yield)
as always, p/e less than market = undervalued
I always think of it as the earnings are the same for the index/treasury so the price must be adjusted to make the ratio equal.
For example if the raito in the fed model is > 1 then the index price must be adjusted upward to make the ratio 1 so the index must be undervalued.
Why is this easier than remembering > 1 = undervalued?