The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion

Posted: 17 Mar 2005

See all articles by Robert A. Weigand

Robert A. Weigand

Washburn University School of Business

Robert R. Irons

Dominican University - Brennan School of Business

Date Written: March 2005

Abstract

We revisit the conventional wisdom that high market P/E ratios forecast negative future stock returns. We identify a significant break in the stock return-P/E relationship at high levels of the market P/E. Starting from market P/E ratios of 21 or greater, 10-year real returns are in line with their long-term historical average, and real earnings growth is well above average. Modeling this break in the data and including the effect of several macroeconomic factors results in forecasts of future returns that are considerably more optimistic than those of previous studies. 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 reciprocal of the E/P ratio, the market P/E, becomes nonstationary about the same time investors begin using the Fed Model (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 be with us for the long term.

Keywords: Fed Model, P/E Ratios, Bond Yields, Mean Reversion, Unit Roots, Nonstationarity, Cointegration

JEL Classification: C22, C53, E39, G14

Suggested Citation

Weigand, Robert A. and Irons, Robert R., The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion (March 2005). Available at SSRN: https://ssrn.com/abstract=683182

Robert A. Weigand (Contact Author)

Washburn University School of Business ( email )

Topeka, KS
United States

Robert R. Irons

Dominican University - Brennan School of Business ( email )

7900 West Division St.
River Forest, IL 60305
United States

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