an average share portfolio is equivalent to around thirty times the annual earnings. the ratio in the united states is even higher, around 35 ( fig. 2 ). price - earnings ratio for sweden and usa affarsvarlden general index and s & p 500 s & p 500 average for 1871 - 1999 note : exceptionally high p / e ratios for sweden in 1992 and 1993 are not shown here sources : global financial data and statistics sweden although long series for the stockholm exchange ’ s p / e ratio are hard to find, it is hardly controversial to say that the present level is well above the historical average. the deviation of share prices from the fundamental conditions that have applied historically is even clearer after a look at the path of real trends in us shares s & p 500, average annual percentage change total real return real share price real earnings / share 1940 - 1981 1982 - 1999 note. averages calculated as geometric mean. somewhat different results may be obtained with an arithmetic mean, an estimated time trend or another base year, but the results still support the conclusion that the earnings trend in recent years is not markedly higher than for the entire post - world war two era. source : global financial data earnings. in the united states the real earnings trend since 1940 has been virtually constant between 2 % and 3 %, while - as i just mentioned - the real return on shares shows a trend break after 1982 ( fig. 3 ). 2 are present share prices fundamentally justifiable? i shall now use a simple model to examine whether the present level of share prices can be justified in fundamental terms. 3 simplifying somewhat, this model equates the value of a share with the present value of the future income the share is expected to generate. a valuation in p / e terms accordingly rests on the assumptions that are made about these future incomes - the future growth of the company ’ s earnings - and the factor by which these incomes are discounted - the stock market ’ s expected return. we can insert alternative values for these assumptions to find the combinations that might justify different p / e ratios ( fig. 4 ). it will be seen that a p / e ratio of 14 can be warranted if the expected real return is 6 % and the real growth of earnings averages 2. 5 %. these figures are all approximately in line with the historical trends. p / e ratios with different combinations of earnings growth & expected return earning earnin s growth % gs expected return % 4. 5 4. 0

- - - 5. 0 6. 0 3. 5 2. 5 trend in order to justify an upward shift in the p / e ratio from just under 15 to between 30 and 35, the expected real return has to be lower and / or expected earnings growth needs to be higher. a p / e ratio at the current level can be explained if, for example : the picture in sweden is somewhat different, with signs of a strengthening of the earnings trend in the period 1982 - 99, though this is not visible in the figure. the krona ’ s depreciation after 1992 seems to have been the main factor here. earnings per share showed little, if any, improvement from 1982 to 1990. however, cyclical fluctuations and changes connected with the krona ’ s marked depreciation should not be central issues for our discussion here. as the stock market trend in both the shorter and the longer term has been largely the same in the united states and sweden and the p / e ratio in both cases is between 30 and 35, there are grounds for assuming that the earnings trend has also been at least approximately the same. see gordon, m j ( 1962 ), the investment, financing and valuation of the corporation, homewood ( irwin ). the simple model is written p / e = d / ( k - g ), where p is the share price, e earnings per share, d the percentage dividend, k the expected return and g the expected dividend growth. – the expected real return has fallen from 6 % to 4 %, or – the expected real earnings trend has risen from 2. 5 % to 4. 5 % a year, or – a fall in the expected real return from 6 % to 5 % has been accompanied by an acceleration of expected earnings growth from 2. 5 % to 3. 5 %. has the expected stock market return fallen? let us begin with the possibility of a lower expected return. does it seem likely? for a long period the expected return, in the united states as well as in sweden, has been stable at around 6 %. so why should things have suddenly changed in recent years in a way that dramatically alters conditions for the long - term valuation of share prices? moreover, a lower expected return would mean that the real return on shares is much the same as on treasury bonds, for example. why would share investment be perceived as having roughly the same risk as investment in bonds issued by a sovereign? but there are