Sir, Christo Leventis (Letters, March 26) rightly points out that the forward price/earnings shares with Cape the characteristic of “smoothing the denominator of the ratio”. So, if noise in the denominator (volatile accounting profit) is interfering with the signal about valuation, why not get rid of fundamental accounting inputs altogether?

Inflation is common to both numerator and denominator in each ratio, so if we drop accounting profit we need to focus on deflated equity price to find our signal. However, if we assume the signal results from some systematic equity-return process, as a function of an adaptive capitalist system, the numerator is better defined as deflated total return, with dividends reinvested.

A ratio of cumulative, logarithmic, real total return against its own long-term regression trend offers a noise-free estimate of valuation for a market index (itself a Darwinian construct). Together with assumptions about the strength and time dependency of reversion to trend, the ratio will also provide an objective estimate of horizon-specific, future, real returns and variances for that index. When fundamental denominators are distorted, the ratio will provide better estimates and when they are not the estimates will be no worse.

Current ratios of market value suggest that no major developed market is significantly different from normal except Japan, which is still undervalued. The implication is that the coincidence of international accounting changes and the credit crisis is still distorting fundamental inputs.

Stuart Fowler,

Director,

Fowler Drew,

London SW6, UK

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