The Time Series Behavior of the Market P/E Ratio: Earnings, Mean Reversion and Forecasting

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Irons, Robert
Weigand, Robert A.
Washburn University. School of Business
Kaw Valley Bank
Issue Date
July 2005
Alternative Title
We analyze periods characterized by high P/E ratios, using measures of the market P/E ratio based on both 1-year trailing earnings (the P/EI) and 10-year smoothed earnings (the P/E10). We find that high P/E periods are preceded by accelerating equity returns and declines in both nominal interest rates and stock market volatility. Stock returns following a high P/E period are marginally higher when earnings growth remains strong and interest rates continue falling. Despite these mitigating factors, however, real returns are appreciably lower for decades following high levels of the market P/E ratio. We also show that the way investors use the "Fed Model" to benchmark the earnings yield on stocks to the 10-year T-note yield has resulted in these two series becoming cointegrated over time. The market earnings yield and its reciprocal, the market P/E, become nonstationary about the same time investors' awareness of the Fed Model apparently increases (ca. 1960), which means that the P/E ratio can stay above trend for an indefinite period of time. The market P/E no longer displays mean-reverting behavior, implying that high P/E ratios could persist for the long term.