The P/E Ratio, the Business Cycle, and Timing the Stock Market

Abstract

Using monthly stock-market data covering 1871–2020, the author analyzes how the price-to-earnings (P/E) ratio is related to future stock-market performance and whether mispricing produces opportunities to time the stock market. The P/E ratio is found to be inversely related to future stock-market performance, as measured by a realized equity premium. The P/E ratio also shows a positive relationship with stock-market fundamentals, as measured by a fair P/E ratio. These findings suggest that the P/E ratio may reflect both misguided market sentiment and rational investor expectations. The cyclically adjusted P/E ratio seems to better reflect mispricing, whereas the conventional P/E ratio better reflects market fundamentals. Mispricing indicated by the P/E ratio does not appear to be significant and systematic enough to produce clear market-timing opportunities. Timing the stock market based on the business cycle, however, appears to be potentially quite lucrative. Typically, stock prices plunge shortly before or during recession and quickly rebound over the next two years or so, creating opportunities to time the market. The potential profit is large, although realizing that profit may involve some complexities related to recession forecasting and tax management. It seems to be a major challenge to explain the overreaction of the stock market to recession within the context of market efficiency.

TOPICS: Security analysis and valuation, fundamental equity analysis, performance measurement, risk management, financial crises and financial market history

Key Findings

• ▪ The P/E ratio reflects both mispricing and market fundamentals. The cyclically adjusted P/E ratio better reflects mispricing, whereas the conventional P/E ratio better reflects market fundamentals.

• ▪ Mispricing indicated by the P/E ratio does not appear to be significant and systematic enough to produce clear market-timing opportunities.

• ▪ Timing the stock market based on the business cycle, however, appears to be potentially quite lucrative. The potential profit is large, although realizing that profit may involve some complexities related to recession forecasting and tax management.