From these elementary principles, with the further assumptions that profitability is both time invariant and high enough to finance growthwithout requiring infusions of new capital, it can be shown that the long run expected return of the stock market is Nominal GDP Growth + (ROE – Nominal GDP Growth)xB/P, where B/P is its book to price ratio (the reciprocal of its price to book ratio), and ROE is its prospective long run return on equity (earnings divided by book value).

Currently, the book to price ratio of the S&P 500 is 0.2. Assume that the ROE of the S&P 500 averages 14% in the future, in between its long term average of 11% and its current value of 18%. Nominal GDP can be expected to grow at about 5% per annum – 3% real growth with 2% inflation. Substituting these figures into the equation gives an expected return of 6.8%, and a risk premium of 0.5%, a far cry from the 3% risk premium that Messrs. Glassman and Hassett posit. If, as they suggest, the risk premium collapses to 0, stock prices will rise at most by 50%. Furthermore, the fair value of the market is exquisitely sensitive to changes in interest rates. A 50 basis point increase in the risk premium can reduce fair value by 25%.

For a different perspective, view stock prices through the eyes of American CEO's. If they thought their equity was enormously undervalued, would they pay for acquisitions with stock? Would entrepreneurs allow investment bankers to take their companies public for a third of their true worth? I believe that the answer to both questions is a resounding no.