THE ECONOMY.

• Position: Review

"The Stock Market: Too High? Too Low? Just Right"

Clement, Douglas

The Region, Federal Reserve Bank of Minneapolis, June 2001, pp. 8-10

In this article, the author summarizes research concluding that "corporate equity is not overvalued." Minneapolis Federal Reserve Bank senior economist Ellen McGrattan and University of Minnesota Regents' professor and Federal Reserve Bank advisor Edward Prescott argue this point, despite opposition from many economists. Unlike others who estimate the market value using current price/earnings ratios relative to historical averages, McGrattan and Prescott look at the market equity value relative to the underlying corporate productive assets for which investors are bidding. Simply put, economic theory says that people should get what they pay for. For further explanation, the article quotes investment "guru" Warren Buffet who believes that the secret to successful investing is buying stock "when businesses sell for less in the market than they are worth." The author states a simplified version of the formula derived by McGrattan and Prescott: Ratio of profits to capital equals the rate of return (capital includ es tangible and intangible capital). Using this formula, they were able to accurately calculate the gross...