Predicting Equity Returns Using Tobin'S q and Price-Earnings Ratios

Abstract

In the spring of 2000, two books predicted a substantial fall in the S&P 500 Index. Robert Shiller's Irrational Exuberance found that, historically, a high price earnings ratio, with real earnings averaged over 10 years, accurately predicts a low real rate of return from investing in the S&P 500 Index. Smithers and Wright's Valuing Wall Street found that a high Tobin's q for the non-financial equities in the S&P 500 does the same. We discover that q beats all variants of the PE ratio for predicting real rates of return over alternative horizons. We also formalize the feedback mechanisms considered in both books.