Abig rally has once again materialised in the US stock market and it has confounded the many pundits who had been forecasting a major correction.
At a time when corporate earnings growth is soft and financial crises abound elsewhere in the world, how is it that speculators seem ready to drive the Dow Jones to yet another record high? It is a question of some importance to Asia because if this rally lacks solid foundations there will indeed be a serious correction and when the US turns sour Asia can turn poisonous.
However, one key principle of investment is at work here. The pricing of a stock market is not dependent primarily on earnings growth or international events but on the returns people can generate relative to their costs of capital.
Look at it another way. Take the price earnings ratio of the US market, which is admittedly near historic highs with stocks on average priced at about 24 times the profits they generate.
Next express this as a percentage return figure. Instead of dividing share price by earnings per share, show the earnings as a percentage of the price. This is called an earnings yield and its usefulness lies in the fact that we measure the returns on almost all other financial assets this way.
We do not, for instance, say that a bank deposit is priced at 20 times earnings. We say that we get a 5 per cent interest rate on it. The same goes for returns on property investments.
Now, as is shown in the accompanying chart, compare this earnings yield against the yield of the US 30-year Treasury bill. The two have gone down together for many years.