Return Predictability and the P/E Ratio

Abstract

The P/E ratio has been used by practitioners and economists as an indicator of market valuations. Shiller [2000] warned that P/E ratios were dangerously high relative to their historical averages. This ratio, however, should in an efficient market vary with factors such as risk, time preferences, inflation, and market expectations. The authors use the residuals from a regression that controls for the effect of these factors on the E/P ratio to provide information about the behavior of the market. They find that the residuals from the model provide a reliable signal of future market behavior.