No. of Recommendations: 2
I think there are three key factors that influence overall stock prices:

1. Expectations for future economic growth. P/e's will be higher when a faster rate of economic growth is expected; lower when future rates are thought to be slower. IMO, it is the change in this expectation that is most responsible for the drop in stock valuations these past two years.

2. Normalization of earnings expectations. One problem with the p/e ratio is that sometimes it's too simple. The market recognizes that spikes and troughs are anomolies. All other things being equal, p/e's are higher during sharp earnings downturns and lower during spiking earnings.

3. Interest rates. The lower the interest rates, the higher the p/e.

In evaluating current stock prices against these stock prices, I think the market is undervalued primarily because of factor #1. At the moment, the market is assuming slow growth in the economy over the coming years. I think the economy is going to recover and, as it does, higher growth expectations will drive the market higher. As for factors #2 and #3, I think the market is reasonably taking these into account at the moment.

--David
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