Compression and Expansion of the Market P/E Ratio

Abstract

Compression and expansion of the average market P/E ratio significantly affected U.S. equity returns in both the bear market of 1969–1981 and the bull market of 1982–1999. We compare two models of the market P/E ratio to determine which paradigm is most useful for financial analysts and portfolio strategists as they anticipate the future direction of the market P/E. We find that the “Fed Model” where investors benchmark the earnings yield on stocks to the 10-year T-note yield—provides a better description of how the market P/E ratio changes over time than the mean-reverting model posited by Campbell and Shiller [1998, 2001]. These results suggest that, as long as inflation and interest rates remain low, high market P/E ratios and the low expected return on equities that accompany high-P/E environments could persist for an extended period