The Market P/E Ratio, Earnings Trends, and Stock Return Forecasts

Abstract

This is an analysis of periods characterized by high price/equity ratios, using measures of the market P/E based on both one-year trailing earnings and ten-year smoothed earnings. 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. Even when these mitigating factors are in place, however, real returns are appreciably lower for decades following high levels of the market P/E ratio. The worst case scenario for future equity returns occurs when P/E ratios expand during periods of strong earnings growth. Once earnings growth slows, equities are left profoundly overvalued, which leads to prolonged periods of low and sometimes negative real returns. The findings suggest that U.S. equities are currently priced to deliver real returns that are positive, but well below their historical average.

TOPICS: Risk management, volatility measures