The Market P/E Ratio: Stock Returns, Earnings, and Mean Reversion
Posted: 17 Mar 2005
Date Written: March 2005
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: Suggested Citation