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The Journal of Investing

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Primary Article

Compression and Expansion of the Market P/E Ratio

The Fed Model Explained

Robert A. Weigand and Robert Irons
The Journal of Investing Spring 2008, 17 (1) 55-64; DOI: https://doi.org/10.3905/joi.2008.701961
Robert A. Weigand
A professor of finance and Brenneman Professor of Business Strategy at Washburn University in Topeka, KS. rob.weigand@washburn.edu
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Robert Irons
An assistant professor of finance at Dominican University in River Forest, IL. rirons@dom.com
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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

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The Journal of Investing
Vol. 17, Issue 1
Spring 2008
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Compression and Expansion of the Market P/E Ratio
Robert A. Weigand, Robert Irons
The Journal of Investing Feb 2008, 17 (1) 55-64; DOI: 10.3905/joi.2008.701961

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Compression and Expansion of the Market P/E Ratio
Robert A. Weigand, Robert Irons
The Journal of Investing Feb 2008, 17 (1) 55-64; DOI: 10.3905/joi.2008.701961
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Cited By...

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More in this TOC Section

  • How Many Mutual Funds Are Needed to Form a Well- Diversified Asset Allocated Portfolio?
  • Return Predictability and the P/E Ratio
  • Estimating the Risk of Guaranteed Products
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