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Time Series Behavior of the Market P/E Ratio: Earnings, Mean Reversion and Forecasting
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Time Series Behavior of the Market P/E Ratio: Earnings, Mean Reversion and Forecasting
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Description
Rating
Title
Time
Series
Behavior
of the
Market
P/E
Ratio
:
Earnings
,
Mean
Reversion
and
Forecasting
Author(s)
Weigand
,
Robert
A.
;
Irons
,
Robert
Description
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
.
Subject
P/ERatios
;
Price/Earnings
Ratios
;
Bond
yields
;
Mean
Reversion
;
Stock
price
forecasting
Publisher
Washburn University, School of Business
Date
July
2005
Type
Working paper
Format
PDF
Series/Report No.
School
of
Business
Working
Paper
Series
;
No
.
44
Language
Eng
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