The Time Series Behavior of the Market P/E Ratio: Earnings, Mean Reversion and Forecasting
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Authors
Irons, Robert
Weigand, Robert A.
Issue Date
2005-07-1
Type
Working paper
Language
en_US
Keywords
P/ERatios , Price/Earnings Ratios , Bond yields , Mean Reversion , Stock price forecasting
Alternative Title
Abstract
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.
Description
Citation
Publisher
Washburn University. School of Business