The Market P/E Ratio,

Earnings Trends, and

Stock Return Forecasts

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Be realistic about returns on equities to come.

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Robert A. Weigand and Robert Irons

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IN
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e investigate the market price/earnings

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ratio and its relation to future stock returns,

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aggregate earnings and interest rates in

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the U.S., a topic that is both popular and
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pressing in current research. Portfolio managers and
academicians alike are well aware of the generally nega-
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tive relation between the market P/E ratio and stock
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returns. The perception that the first one or two decades

of the 21st century are likely to be characterized by low
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returns and below-average equity risk premiums has thor-

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oughly permeated the money management industry, and

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has influenced the way portfolio managers invest and com-

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municate with clients.

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For example, it is now common for active money

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managers to emphasize the importance of low-cost strate-

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gies in their search for alpha, as they realize that in a low-

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return environment a differential return of even 1 to 2

percentage points per year could significantly improve the
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long-term performance of the portfolios they manage.

ROBERT A. WEIGAND Developing a better understanding of the relation between
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is a professor of finance the market P/E ratio and stock returns, earnings growth,
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and Brenneman professor and interest rates is therefore a prime topic for portfolio
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of business strategy in the managers and institutional investors.

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Washburn University
School of Business in
We develop forecasts of ten-year real stock returns
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Topeka, KS. based on the level of the market earnings yield (E/P ratio,
rob.weigand@washburn.edu or the reciprocal of the market P/E ratio), and find that
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our forecasts are not as pessimistic as those made elsewhere,

ROBERT IRONS
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although the forecasted returns are significantly lower than

is an assistant professor of those to which investors have become accustomed in the
finance in the Brennan
School of Business of
past half century. We examine the relation between P/E
Dominican University in ratios and future returns using two measures of the market
River Forest, IL. P/E: the metric more popular among the investing public,
rirons@dom.edu using one-year trailing earnings (the P/E1), and the metric
SUMMER 2007 THE JOURNAL OF PORTFOLIO MANAGEMENT 87
Copyright © 2007
favored by academicians, using ten-year smoothed earn-
ings (the P/E10).
Our results indicate that the average relation
between future earnings and returns and the market P/E
ratio is similar for both measures of the P/E, except in
the case of very high market P/E ratios (over 20). Average
real earnings growth and real stock returns are negative
for the ten years following very high P/E10 periods.
After the onset of very high P/E1 periods, however, real
earnings growth is strong, and real stock returns are
positive although lower than their long-term historical
average.
The key variable that determines whether future
returns will be negative or just disappointingly low is earn-
ings, particularly whether a temporary dip in earnings
contributes to a high market P/E1 ratio. When the market
P/E1 peaks in this manner, earnings provide support for
equity valuations as recent growth in earnings persists for
several years, and the stock returns that follow are posi-
tive, if usually below average. When equity prices surge
beyond fast-growing earnings during high P/E1 periods,
however, equities are left significantly overvalued just as
earnings growth begins to slow. These periods of over-
valuation are predictably followed by protracted bear
market returns.
We develop forecasts of future stock returns using
two different approaches. The first models the break in the
P/E ratio-stock return relation for P/Es higher than 20,
and includes the effect of real earnings growth and changes
in inflation over the previous decade and the prior realized
20-year volatility of stocks and bonds in the forecasting
regressions. The second model is more parsimonious,
obtaining approximately the same level of explanatory
power by focusing on only two variables, the market
earnings yield and the ratio of short-term to long-term
earnings (E1/E10).
Both sets of forecasts suggest the persistently high
level of the market P/E does not portend as bleak a
future for U.S. stock returns as has been indicated by
previous studies, even though the forecasted returns are
well below the market average since 1946. Our fore-
casts fall between those of the doomsayers who predict
complete mean reversion of the market P/E ratio and
the pundits whose predictions assume that stocks are
perennially poised to deliver their reliable 10%-12% of
the previous century. Our results suggest that both out-
looks are too extreme. We conclude that the U.S. will
remain mired in a low-return environment for the fore-
seeable future.
88 THE MARKET P/E RATIO, EARNINGS TRENDS, AND STOCK RETURN FORECASTS
Copyright © 2007
DATA AND TERMINOLOGY
The stock price index, inflation, P/E ratio, and earn-
ings data used in the study are taken from the database gen-
erously maintained by Shiller [2006] (and available for
download from his website). Interest rate data are obtained
from the Federal Reserve Economic Database (FRED II),
and the current market P/E ratio and dividend yield are
obtained from the New York Federal Reserve Bank
website.
Shiller’s data, at the time they were accessed for this
study, extend from January 1871 through June 2004. We
focus on the 1,360 overlapping ten-year periods that begin
with each month from January 1881 through June 1994.
Studying this period allows us to analyze the ten-year
periods preceding and following each month in the data-
base, so our analysis employs all of the Shiller data over
1871-2004. As our regressions use smoothed (overlapping)
data, the reported t-statistics use autocorrelation-consistent
standard errors following Newey and West [1987].
The data are adjusted for inflation. Unless otherwise
specified, all references to stock returns and earnings growth
are to total real stock returns and growth in real earnings.
Monthly P/E ratios are calculated using each month’s real
price and one-year trailing earnings (the P/E1), as well as
a P/E ratio calculated from ten-year smoothed earnings (the
P/E10) as in Campbell and Shiller [1998, 2001]. The first
metric is more widely referenced by everyday market par-
ticipants, while the second metric is thought to be com-
putationally superior as it is less affected by short-term
fluctuations in reported earnings.1
As there is no universal definition of what constitutes
a high P/E ratio, we use the ten high P/E1 periods cited
by Siegel [2002b, pp. 96-97]. The Shiller data reveal that
Siegel’s high P/E periods begin when the P/E1 ratio climbs
above 20. We therefore also identify the six periods when
the market P/E10 period rises above 20, and compare these
to the high P/E1 periods.
MARKET P/E RATIOS AND
FUTURE RETURNS REVISITED
The idea that unusually high or low market valua-
tion ratios lead to extreme future stock price changes is
well established in the literature. For example, Campbell
and Shiller [1998, 2001] show that an extremely low
market dividend yield provides a reliable forecast of future
declines in stock prices. Mean reversion in the ratio occurs
almost exclusively in an adjustment of prices rather than
SUMMER 2007
dividends. Campbell and Shiller also show that an unusu-
ally high market P/E ratio forecasts poor future stock
returns, as it is stock prices, not earnings, that account
for most of the ratio’s reversion to its historical mean.
Given the market P/E ratios in the late 1990s, they pre-
dict that U.S. equities will lose 40% of their value over the
period 1997-2006.
Shiller [2002, p. 88] sums up this line of thinking:
“When the price earnings ratio has been high, let’s say
between 20 and 25, the real return over the next ten years
has been meager or negative.”
Siegel [2002b] points out that all periods character-
ized by high P/E ratios are not created equal. When P/E
ratios spike upward from sharp declines in earnings, the real
return to equities averages 9.7% annually for the next five
years. When they rise sharply due to overoptimistic surges
in stock prices, however, equities deliver real returns of
only 1.1% per year for the next five years. Siegel also asserts
that there is no fundamental reason the “normal” P/E
ratio cannot change over time, suggesting that the cur-
rently high market P/E need not revert all the way to its
historical average before stocks are once again priced to
deliver positive expected returns.
Carlson, Pelz, and Wohar [2002] present statistical
evidence that supports Siegel’s claim, showing that the
market P/E may have shifted upward to a new mean value
in 1992. They estimate the new normal bound for the
market P/E ratio is between 20 and 25, which is consid-
erably higher than its long-term historical average of 15.
Both Siegel and Carlson et al. stress that this shift implies
future stock returns will be much lower than the 10%-12%
per year earned in the 20th century.
Many other authors also forecast a lower equity risk
premium over the next several decades. Among the most
recent examples are Glassman and Hassett [1999], Siegel
[1999, 2002a], Asness [2000], Shiller [2000], Arnott and
Ryan [2001], Campbell and Shiller [2001], Claus and
Thomas [2001], Arnott and Bernstein [2002], Fama
and French [2002], Ritter and Warr [2002], Ibbotson and
Chen [2003], Ilmanen [2003], and Polk, Thompson, and
Vuolteenaho [2006]. Among the few dissenting voices on
this topic is Mehra [2003], who focuses on the very long
run and concludes that: “Over the long term, the equity
premium is likely to be similar to what it has been in the
past” (p. 67).
One aspect of these dire warnings for the future per-
formance of U.S. equities has apparently gone unrecog-
nized by previous research: The way the earnings in the
market P/E ratio is measured can result in dramatically
SUMMER 2007
Copyright © 2007
different forecasts of future returns when starting from a
historically high ratio. Consider Exhibit 1, which depicts
an XY scatterplot of the P/E1 ratio at the start of each
ten-year overlapping period from 1881-1994 versus the
subsequent annualized ten-year total real return to U.S.
stocks. The least squares line from a regression of ten-
year real returns on the starting level of the P/E1 ratio is
also shown.
It is clear from examination of Exhibit 1 that the
general negative relation between starting P/E1 ratios and
ten-year real returns changes abruptly for P/E1 ratios
higher than 20. Ten-year returns starting from high P/E1
ratios have never been severely negative. Although the
overall trend of the P/E1 and stock return relation is neg-
ative, the lowest ten-year real returns are earned starting
from market P/E1 ratios between 12 and 20. Protracted
declines in the value of U.S. equities starting from higher
levels of the market P/E1 ratio are rare.
Next consider Exhibit 2, which depicts an XY scat-
terplot of the P/E10 ratio at the start of each ten-year
overlapping period versus the annualized ten-year real
return to U.S. stocks. In comparison to Exhibit 1, several
items are noteworthy. First, the slopes of the least squares
regression lines are nearly identical: -0.0061 for the P/E1
ratio versus -0.0072 for the P/E10 ratio.2
Second, the major difference between these ratios
and their relation to future stock returns occurs in the high
P/E range. In Exhibit 1, the scatterplot lies above the regres-
sion line for high P/E1 values. In Exhibit 2, the scatter-
plot is more evenly distributed above and below the
regression line for high P/E10 values, and is influenced by
EXHIBIT 1
Scatterplot of Market P/E1 Ratio (1-Year Trailing
Earnings) versus Subsequent 10-Year Return
THE JOURNAL OF PORTFOLIO MANAGEMENT 89
EXHIBIT 2 a few periods when the P/E10 ratio was higher than 25
and followed by extremely negative returns.
Scatterplot of Market P/E10 Ratio (10-Year Smoothed
Earnings) versus Subsequent 10-Year Return The average relation between the market P/E and
future returns is similar for both the P/E1 and P/E10
ratios, however. The small difference in the slopes of the
regression lines is due primarily to the stock returns that
are earned starting from historically high values of each
ratio.
The data presented in Exhibit 3 elaborate on these
points in greater detail. The exhibit is created by sorting
the following variables into equally sized quintiles based
on the P/E1 and P/E10 ratios at the start of each ten-year
overlapping period 1881-1994: average annual ten-year
real stock returns; the standard deviation of annual returns
over the same period; annual real earnings growth for the
ten-year windows preceding and following the start of each

EXHIBIT 3
Stock Returns, Earnings, and Inflation Sorted by Starting P/E Ratio

90 THE MARKET P/E RATIO, EARNINGS TRENDS, AND STOCK RETURN FORECASTS SUMMER 2007

Copyright © 2007
overlapping period; and the annual percentage change in
the consumer price index for the same pre- and post-ten-
year windows. We also report the value of these variables
for the overlapping ten-year periods that begin from
market P/E ratios higher than 20.
Panel A of Exhibit 3 shows that real stock returns
generally decline through the first four quintiles of the
P/E1 ratio. On average, ten-year returns to U.S. equities
are higher when the market starts from lower P/E1 ratios.
Real earnings growth displays the opposite tendency, gen-
erally increasing with the starting level of the P/E1 ratio.
This prompts us to investigate whether inflation rises in
the higher P/E1 periods, as several authors assert that the
real earnings growth of levered firms displays a positive
correlation with inflation (Modigliani and Cohn [1979]
and Ritter and Warr [2002]).
The data presented in Exhibit 3 reveal this is not
the case, however. The annual percentage change in the
CPI over the same ten-year window displays no tendency
to increase following the onset of a high P/E1 period.
Exhibit 3 corroborates the results shown in Exhibit 1,
namely, that the tendency for real ten-year returns to
decline as the starting P/E1 rises does not hold for the
highest P/E1 quintile. Average real equity returns are pos-
itive, albeit well below average (4.54%), when the market
starts from P/E1 ratios of 17.6 or higher. Note that these
observations account for 20% of market outcomes over
1881-1994.
Turning our attention to the 6% of the observations
that begin with market P/E1 ratios higher than 20, we
see that this reversal effect continues all the way out to the
tails of the distribution. Stocks deliver ten-year real returns
that are in line with their long-term historical average
(7.24%) when starting from P/E1 ratios higher than 20.3
Moreover, the high P/E1 periods are associated with
some of the strongest rates of long-term real earnings
growth on record. High P/E1 periods are preceded by
prolonged earnings recessions that are reversed during the
decade following.
Panel B of Exhibit 3 shows the relation between the
P/E10 ratio and real stock returns is similar to the results
reported in Panel A for the first four quintiles. Real stock
returns are lower when starting from higher levels of the
market P/E10 ratio.
As revealed in our comparison of Exhibits 1 and 2,
the main difference between the ratios is evident in the
higher P/E quintiles. The mean annual real stock return
is only 2.35% for the subsequent decade when starting
from the highest quintile of the market P/E10. The results
SUMMER 2007
Copyright © 2007
are worse for the overlapping periods starting from P/E10
ratios higher than 20. Ten-year real returns average
−0.15% per year following periods when the market
P/E10 rises above 20.
Real earnings growth before and after the high P/E10
periods is also different compared with the high P/E1
periods. During the decades leading up to the high
P/E10 period, real earnings growth is accelerating, but
this reverses in the next decade. High P/E10 periods are
followed by ten-year average growth in real earnings of
only −0.59% per year versus the strong 5.01% per year
following high P/E1 periods.
The results reported in Exhibit 3 further reinforce
the idea that the most important differences between the
P/E1 and P/E10 occur when these metrics reach their
highest levels. For this reason, we report a wider range of
macroeconomic and financial variables before and after the
high P/E1 and P/E10 periods in Exhibits 4-7. The pre-
sentation in these exhibits is slightly different from the
presentation in Exhibit 3 “which shows” (average real
returns and earnings growth before and after all the over-
lapping P/E periods, which means that many of the obser-
vations are drawn from the same high P/E regimes).
In Exhibits 4-7 we report the performance of key
variables before and after the first month when either the
P/E1 or P/E10 ratio rises above 20 (which we define as
the start of a high P/E period). The annualized perfor-
mance of each variable is reported for the one-, five-, and
ten-year windows preceding and following the start of
the high P/E periods.
Exhibit 4 shows real stock returns leading up to and
after the first month of each high P/E1 and P/E10 period.
When the data are reported this way, the apparent differ-
ences in real returns are not as pronounced. Stock market
performance is accelerating leading up to the start of each
high P/E period, and reverses quickly thereafter. The ten-
year real returns are particularly disappointing, averaging
2.59% per year after high P/E1 periods and −0.64% per
year after high P/E10 periods.
Exhibit 5 shows a significant difference in earnings
growth before and after high P/E1 and P/E10 periods.
The high P/E1 periods are preceded by prolonged earn-
ings recessions, with real earnings declining most sharply
in year −1 relative to the first high P/E1 month. This
trend dramatically reverses in the next year, leading to
strong earnings growth over the subsequent decade.
A distinctly different pattern emerges before and after the
high P/E10 periods. Earnings growth is accelerating
leading up to the first high P/E10 month. Although the
THE JOURNAL OF PORTFOLIO MANAGEMENT 91
EXHIBIT 4
Comparison of High P/E Periods: Real Stock Returns
*The 10-yr post column for Feb 1997 is only 7 years post for reasons of data availability (1997-2004).
fast growth continues into the first year of the high P/E10
period, the five-year growth rate moderates, and ten-year
growth in real earnings averages only 0.24% per year,
indicative of a sustained earnings slowdown.
The patterns in real returns and earnings growth
in Exhibits 4 and 5 help explain both the onset and the
unwinding of the high P/E periods. Rising stock prices
over the previous decade result in increases in both the
P/E1 and P/E10 ratios. The increase in the P/E1 is also
driven by declining earnings, however, while the P/E10
reaches historically high levels as stock prices rise at a faster
rate than real earnings, which are also increasing. The dif-
ference in stock returns in the decade after high P/E
periods is due in part to earnings growth, which rebounds
following high P/E1 periods but decelerates after high
P/E10 periods.
Rising earnings provide support for equity values
following the high P/E1 periods, which would explain
92 THE MARKET P/E RATIO, EARNINGS TRENDS, AND STOCK RETURN FORECASTS
Copyright © 2007
why real stock returns are moderately higher than real
returns following high P/E10 periods. Earnings growth
provides no relief for stock valuations after the onset of
high P/E10 periods, however, which contributes to the
negative real returns that persist for the decade following.
The data show that patterns in inflation are virtu-
ally identical before and after the two types of high P/E
periods (reported in Exhibit 3), but stock returns fol-
lowing high P/E1 periods are apparently also getting a
boost from declines in nominal interest rates. The level
of real rates is similar before and after each event (results
not shown), but there are important differences in changes
in nominal T-note yields (Exhibit 6). Nominal yields are
falling leading up to both types of high P/E periods, but
continue declining for the decade after the high P/E1
regimes. After high P/E10 periods, however, yields reverse
direction, and then hold steady for most of the subse-
quent decade.
SUMMER 2007
EXHIBIT 5
Comparison of High P/E Periods: Real Earnings Growth
*The 10-yr post column for Feb 1997 is only 7 years post for reasons of data availability (1997-2004).
The decline in yields leading up to both high P/E
periods, and their continued decline following high P/E1
periods, is, of course, reminiscent of a Fed model story,
where investors use lower interest rates to rationalize
higher P/E ratios. As argued by Asness [2003] and others,
one of the flaws in the Fed model is that investors suc-
cumb to money illusion, focusing on nominal instead of
real interest rates.
The falling nominal interest rates reported in
Exhibit 6 are consistent with investors resorting to Fed model
logic to justify higher P/E ratios, which would also partly
explain the marginally higher stock returns earned after high
P/E1 periods. These patterns are evident in the data since
the 1800s, which also supports Asness’s [2003] finding that
investors had applied the Fed model to relative stock and
bond valuation long before the late 1950s-early 1960s.
Asness [2003] shows that the Fed model holds
since the 1800s when the model is amended to account
SUMMER 2007
Copyright © 2007
for time-changing stock and bond volatility. We examine
this finding in greater detail in Exhibit 7, which presents
the standard deviation of annual stock returns for the one-,
five-, and ten-year windows preceding and following the
high P/E periods. The results are striking. Investors have
apparently been prey for a long time to another argument
for rationalizing high P/E ratios that is still in vogue
today: “Higher P/E ratios are justified when the risk of
equities is ‘permanently’ lower.”
Exhibit 7 reveals a steady decline in stock return
volatility during the decade preceding the high P/E
periods. The pattern manifests itself for 14 of the 15 high
P/E periods (May 1933 is the exception; it was driven
by a strong earnings recession). The decline in perceived
equity risk is, of course, not permanent, and consistently
reverses course over the next ten-year period. This increase
in volatility is in all likelihood another factor that con-
tributes to compression in both measures of the market
THE JOURNAL OF PORTFOLIO MANAGEMENT 93
EXHIBIT 6
Comparison of High P/E Periods: Changes in Nominal 10-Year T-Note Yields
*The 10-yr post column for Feb 1997 is only 7 years post for reasons of data availability (1997-2004).
P/E ratio and the poor equity returns earned over the
subsequent ten years.
Effect of Earnings on the
Market P/E and Future Returns
Here we revisit the evidence presented in Exhibit 5,
which shows that earnings growth accelerates leading up
to high P/E10 periods and decelerates leading up to high
P/E1 periods, with these patterns reversing in the decades
following. This finding is reminiscent of Siegel’s [2002b]
conclusion that high market P/E ratios resulting from
sharp declines in earnings are followed by average stock
returns, but high market P/Es due to overoptimistic surges
in stock prices are followed by returns that are well below
average.
To capture the different earnings growth patterns
preceding the two types of high-P/E periods, we define
94 THE MARKET P/E RATIO, EARNINGS TRENDS, AND STOCK RETURN FORECASTS
Copyright © 2007
a new variable, E1/E10, the ratio of one-year trailing
earnings to ten-year smoothed earnings. We show that
the E1/E10 ratio provides information regarding how the
market P/E ratio became elevated, and is therefore useful
in determining whether a high P/E period is likely to be
followed by disappointing returns. A high E1/E10 ratio
indicates current earnings are above their long-term trend,
and a low E1/E10 indicates current earnings are below
their long-term trend.4
When both the market P/E ratio and the E1/E10
are high, stock prices are high relative to long-term sus-
tainable earnings. Recently rising prices are therefore
unlikely to receive support from future earnings growth,
as earnings have recently grown at a pace above trend.
These are truly expensive markets.
When the market P/E is high and the E1/E10 is
low, however, stock prices are high only relative to short-
term earnings, which are temporarily depressed. In this
SUMMER 2007
EXHIBIT 7
Comparison of High P/E Periods: Volatility of Real Stock Returns
*The 10-yr post column for Feb 1997 is only 7 years post for reasons of data availability (1997-2004).
case, earnings have room to grow and provide support
for high equity valuations, and subsequent stock returns
need not be disastrous.
We further propose the E1/E10 ratio is most useful
in supplementing the information content of the P/E1
ratio, which, unlike the P/E10, makes no statement about
how expensive equities are compared to long-term sus-
tainable earnings. We show that interpreting the P/E1 ratio
in conjunction with the E1/E10 enhances the P/E1’s pre-
dictive ability, and reconciles differences in forecasts based
on the P/E1 and P/E10 ratios (shown in the next section).
Exhibit 8 reports ten-year real stock returns over
1881-1994 and 1946-1994 sorted by tritiles of starting
P/E1 ratios. Each P/E1 tritile is further sorted by the
E1/E10 ratio at the start of the period. When the E1/E10
ratio is low, resulting from short-term earnings recessions,
SUMMER 2007
Copyright © 2007
the P/E1 ratio provides little information about future
returns, which are reliably positive for the subsequent
decade. Regardless of the level of the P/E1 ratio, stocks
bounce back from the low E1/E10 earnings recessions
and deliver consistently positive returns for the next decade.
When the E1/E10 ratio is high, however, the market
P/E1 ratio provides more information regarding future
returns, similar to that provided by the market P/E10
ratio. When both the P/E1 and E1/E10 are high, it means
equities are richly valued despite recent strong earnings
growth. These are the truly expensive markets, and returns
are disastrous for the next decade. When the P/E1 ratio
is low and the E1/E10 ratio is high, however, stocks are
cheap just as earnings begin bouncing back from pro-
longed earnings recessions. These conditions reliably signal
the start of the best bull market periods.
THE JOURNAL OF PORTFOLIO MANAGEMENT 95
EXHIBIT 8
10-Year Real Stock Returns, Market P/E1
Ratio, and E1/E10 Ratio
Forecasts of Future Returns
Based on Market E/P Ratio
What can the level of the market E/P ratio tell us
about future stock returns? We compare the results of two
types of forecasts. The first forecast is more conventional,
based on the market E/P ratio and the break in the return-
E/P relation at low levels of the market E/P (5% or lower,
corresponding to market P/E ratios of 20 and above), and
includes the effect of macroeconomic variables that are
shown elsewhere to affect stock returns. The alternative
forecasts use a more parsimonious model, achieving sim-
ilar levels of explanatory power using only the market
E/P and E1/E10 ratios.
The first set of forecasting regressions follows the
general form depicted in Equation (1):
10 - Yr Real Ret = a + g1( E / P ) + g2 ( Dummy E / P ≤ 5%)
+ g3 (G in Real E−10 )
+ g4 ( Annual ∆CPI −10 )
+ g5 ( 20Yr sS ) + g6 ( 20Yr sB ) + e
Ibbotson and Chen [2003] identify real earnings
growth and inflation as two key determinants of equity
returns. The results reported in Exhibits 3, 5, and 8 reveal
interesting patterns in real earnings growth during the
ten-year windows preceding and following the high P/E
periods. For example, periods starting from P/E1 ratios
higher than 20 are associated with negative rates of real
earnings growth over the prior ten years. These earnings
recessions exhibit a strong reversal in the next decade, as
96 THE MARKET P/E RATIO, EARNINGS TRENDS, AND STOCK RETURN FORECASTS
Copyright © 2007
the high P/E1 periods are associated with rapid growth in
real earnings. Conversely, the high P/E10 periods are pre-
ceded by positive growth in real earnings, but average real
earnings growth is close to zero for the subsequent decade.
Inflation over the prior ten-year periods also dis-
plays interesting patterns. For both measures of the market
P/E, lower P/E starting points are associated with higher
inflation, indicating that relative market valuation is sup-
pressed when the price level rises rapidly. Similarly, periods
when P/E ratios are higher are preceded by lower rates
of inflation.
Asness [2000] shows that equity expected returns are
positively related to investors’ long-term expectations of
relative stock and bond volatility; we therefore include the
standard deviation of annual stock and bond returns over
the previous two decades in the regressions. The expected
signs of the regression coefficients on 20Yr sS and 20Yr sB
are positive and negative, respectively, reflecting the idea
that investors price equities for higher (lower) expected
returns when stocks are more (less) volatile than bonds.
As argued by Merton [1980], however, realized stock
returns are a noisy proxy for expected returns. It is there-
fore also possible that each volatility measure will take a
positive sign, as risk-averse investors require higher expected
returns when either asset class becomes more volatile.
Exhibit 9 presents regression results based on the E1/P
ratio (Panels A and B) and the E10/P ratio (Panels C and
D). All regressions have significant explanatory power over
both the full period 1881-1994 and the 1946-1994 sub-
period. For reasons of brevity, we focus on the subperiod
results and the forecasts based on those regressions.
Panel B reports results based on the E1/P ratio. The
2
R s of the regressions range from 33% (E1/P ratio only)
to 53% [full model as depicted in Equation (1)]. The model
explains a significant amount of the variation in ten-year
returns to U.S. equities. The coefficients on the E1/P ratio
(g1 ) and the variable capturing the effect of E1/P < 5%
(g2 ) are significant in all the models estimated. Prior-
(1) period inflation and growth in real earnings are signifi-
cant determinants of the future 10-year return to stocks,
as are the 20-year trailing volatility measures. All the regres-
sion coefficients are of the expected sign, with the excep-
tion of the coefficient on the ten-year prior growth in
earnings, which changes sign in the subperiod regression.
Real returns are positively related to the trailing
volatility of stocks and bonds. This is consistent with the
idea that time-varying expected returns increase when
perceived risk is higher, and decline when perceived risk
is lower.
SUMMER 2007
EXHIBIT 9
Regressions of 10-Year Real Stock Returns on Various Measures

**, *Significant at the 0.01 and 0.05 levels, respectively.

SUMMER 2007 THE JOURNAL OF PORTFOLIO MANAGEMENT 97

Copyright © 2007
 We obtain our forecast by plugging into Equation (1)
the inputs: market E1/P ratio of 4.63%; average annual
rate of CPI inflation over 1995-2004 (2.38%); average
annual growth in real earnings over the same period
(5.89%); and 20-year trailing volatility of stocks and bonds
(14.91% and 14.44%, respectively):5
−0.39453 + 0.39033(0.0463) + 0.02479 + 0.12809(0.0589)
+ 1.91627 (0.0236 ) + 0.9741(0.1491)
+ 1.47396 (0.1444 ) = 0.0592 = 5.92% (2)
The forecast from this model is considerably more
optimistic than the predictions of Campbell and Shiller
[1998, 2001], and comparable to the expected return for
equities estimated by Ibbotson and Chen [2003], who
forecast a ten-year average real return of 5.4%.
As expected, forecasts based on the E10/P ratio are
somewhat more pessimistic. Results from the E10/P fore-
casting regressions (Panel D) are shown in Equation (3)
(using the current market E10/P ratio of 3.72%):
−0.50335 + 0.92546 (0.0372) − 0.01239 + 0.23383(0.0589)
+ 1.40514 (0.0236 ) + 1.09466 (0.1491)
+ 2.07484 (0.1444 ) = 0.0284 = 2.84% (3)
These forecasts are 3.1 percentage points lower than the
forecasts from the E1/P forecasting model, primarily because
of the difference in the coefficient on the E/P < 5% dummy
variable (3.7 percentage points lower in the E10/P model).
This finding was anticipated by the visual evidence pre-
sented in Exhibits 1 and 2, which shows that the main
difference between the P/E1 and P/E10 ratios is their rela-
tion to future returns starting from values higher than 20.
Although the model forecasts higher returns than those
predicted by Campbell and Shiller [1998, 2001], the fore-
casts confirm the results of prior studies, namely, that U.S.
securities markets remain mired in a low-return environment.
The results suggest the real return to U.S. equities will be
between 2.8% and 5.9% for the next ten years, consider-
ably below the long-term average real return of 7.1%.
Our second set of forecasts uses a more parsimo-
nious model, featuring only the market E/P ratio and the
E1/E10 ratio (one-year current earnings divided by ten-
year smoothed earnings). We also include a term in the
regression to model the interaction between the market
earnings yield and the E1/E10 ratio, which, as shown in
Exhibit 8, accounts for the way the market P/E becomes
98 THE MARKET P/E RATIO, EARNINGS TRENDS, AND STOCK RETURN FORECASTS
Copyright © 2007
elevated (a temporary drop in earnings versus an overop-
timistic surge in stock prices).6
The second forecasting model is shown as
Equation (4):
10 - Yr Real Ret = a + l 1(E / P )
+ l 2 (E1 / E10 )
+ l 3 (E / P × E1 / E10 ) + ε (4)
Results of the regression for both the E1/P and
E10/P ratios are reported in Exhibit 10. We estimate the
model using data for 1881-1994 and 1946-1994 and, as
above, focus on the period 1946-1994. The interaction
term is significant in the E1/P regression only. This result
is not unexpected. We have noted that the E1/P ratio’s
forecasting ability is supplemented by the E1/E10 ratio,
which captures the relative behavior of short- and long-
term earnings. This information is already reflected in
the E10/P ratio (thus the insignificance of the interac-
tion term).
The model has explanatory power similar to the more
conventional model first estimated, with adjusted R2 ranging
from 35% to 40%. The significance of the E1/E10 ratio in
explaining future returns in conjunction with the market
earnings yield is further underscored by the fact that the
E/P < 5% dummy variable is insignificant when included
in the models reported in Exhibit 10 (results not shown).
The E1/E10 variable accounts for the difference in future
returns when the market P/E ratio becomes elevated. These
findings suggest that stock returns in high P/E environ-
ments are influenced by the effect of short- and long-term
earnings on the level of the market P/E ratio.
Using the current market E1/P ratio of 4.63% and
the E1/E10 ratio of 1.31, we obtain a ten-year real return
forecast of 4.13%. As for the first model, the forecasts are
lower when the E10/P ratio (current value 3.72%) is used
in the regression. In this case, the forecast is for ten-year
real returns of 2.99% per year.
Interpreting the Forecasts
Our results indicate that the ten-year forecasts of
nominal stock returns are less bleak than suggested by other
authors. Our forecasts range from 2.8% to 5.9% per year
for the next decade according to the more conventional
earnings yield and macrofactors forecasting model, and
from 3.0% to 4.1% according to the more parsimonious
SUMMER 2007
EXHIBIT 10
Regressions of 10-Year Real Stock Returns on Starting E/P Ratios and E1/E10 Ratio
**, *Significant at the 0.01 and 0.05 levels, respectively.
earnings yield and E1/E10 forecasting model. These fore-
casts are, of course, considerably below the long-term
average performance investors have come to expect from
U.S. stocks. With the ten-year T-note currently yielding
5%, the forecasts imply the forward-looking equity
risk premium is at most 1 percentage point, and possibly
negative.
There is nothing in these results that suggests an
optimistic scenario for U.S. equity returns. With accel-
erating inflation, high energy prices, decelerating eco-
nomic growth, and considerable global uncertainty, further
compression of the market P/E ratio and a concomitant
expansion of the equity risk premium seems a more likely
scenario than a stock market boom featuring sustained
double-digit returns.
An additional concern for future returns is that both
the P/E10 and P/E1 ratios remain high, 24 and 18, respec-
tively, as of the time of this writing, and the E1/E10
ratio is well above average at 1.31. How the length of the
SUMMER 2007
Copyright © 2007
current high P/E period affects our forecasts is unclear, as
our forecasts are based on prior high P/E events that were
not nearly as long-lived. In the 1890s, P/E ratios stayed
above 20 for 15 months. In 1933-1934, the market P/E
remained above that level for 13 months. From 1961-1962,
P/E ratios remained above 20 for a ten-month period.
Only in the 1990s-2000s have we seen such
extended periods of high P/E ratios. Over 1991-1994, the
market P/E remained above 20 for 31 months. The most
recent high-P/E period began in July 1997, continuing
through December 2005 for an all-time record of 103
consecutive months.
Suffice it to say that the extent of the most recent
high-P/E period leaves markets in potentially perilous
new territory, a territory as little understood as any period
in the history of investing.
The results presented in Exhibits 4-7 provide insight
into the effect of macroeconomic and financial conditions
on stock returns following high P/E periods. For example,
THE JOURNAL OF PORTFOLIO MANAGEMENT 99
higher earnings growth partially “bails out” high market
valuations, leading to marginally higher stock returns com-
pared with high P/E periods that are followed by slow
growth in earnings. Earnings have shown a strong recovery
in 2003-2006, but would have to continue growing above
their long-term trend (4.1 percentage points above infla-
tion since 1946) to provide support for current equity
valuations.
The Shiller [2006] dataset shows that only 4% of
the ten-year overlapping periods since 1881 have been
characterized by real earnings growth rates averaging 8%
or better. Decades when growth in real earnings averages
5% are uncommon, so counting on rapid earnings growth
to completely resolve the market’s long-standing valua-
tion crisis borders on the fanciful.
Declining interest rates have also buoyed stock returns
following high P/E periods. The Federal Reserve’s con-
cerns about inflation and the recent conduct of monetary
policy make it unlikely that bond yields will be much help
this time around, however. Our results also show that com-
pression of the market P/E ratio and lower real stock returns
have been associated with rising stock market volatility
following high P/E events. Lingering concerns regarding
accounting fraud, ongoing conflict in the Middle East,
and uncertainty regarding future energy prices and infla-
tion make it unlikely that stock investors will enjoy the
low stock volatility that characterized the brief bull run of
2003. Earnings growth appears to be the only factor in
place that has the potential to mitigate the impact of high
market P/E ratios on future stock returns.
CONCLUSIONS AND IMPLICATIONS
We analyze periods characterized by high P/E ratios,
using a dataset extending back to the 1880s. We examine
two measures of the market P/E ratio, using one-year
trailing earnings (the P/E1) and ten-year smoothed earn-
ings (the P/E10). Comparing the two measures adds to
our understanding of the factors contributing to the onset
of high P/E periods and the long-term stock returns that
follow these episodes.
High-P/E periods are preceded by accelerating
equity returns and declines in both nominal interest rates
and stock market volatility. Following these periods, stock
returns are marginally higher when earnings growth is
strong and interest rates continue falling. In particular,
high-P/E periods triggered by temporary earnings declines
are followed by low positive stock returns, but returns are
negative for at least a decade when earnings grow rapidly
100 THE MARKET P/E RATIO, EARNINGS TRENDS, AND STOCK RETURN FORECASTS
Copyright © 2007
and the market P/E climbs above 20. Following both
types of high-P/E events, however, real stock returns are
appreciably lower than average for the subsequent decade.
Our conclusions support the large body of recent
research that suggests the expected return on U.S. stocks
will be substantially lower than the returns earned during
the 20th century. There are compelling reasons for
investors to be realistic regarding the maximum potential
return from equities in the early 21st century.
ENDNOTES
The authors appreciate the comments of Clifford Asness,
Larry Gorman, Antti Ilmanen, Kevin Kneafsey, Kenneth
Kroner, Tuomo Vuolteenaho, and Thomas Zwirlein, and par-
ticipants at the 2004 meetings of the Financial Management
Association.
1
Whenever we refer to the market P/E or E/P ratios
without the numerals 1 or 10, we are intentionally making gen-
eral observations about the ratios.
2
Forecasts of ten-year real returns based on the more stable
E/P ratio are reported in Exhibits 9 and 10.
3
Siegel [2002b] shows that the average real return to U.S.
equities was 7.1% per year over 1946-2001.
4
The E1/E10 ratio in the U.S. has had a long-term average
of 1.082 (since 1881). Since 1946, the ratio has ranged from a
low of 0.65 (in 2002) to a high of 1.62 (in 1950). From 1881
to mid-2004 the E1/E10 ratio has been above its long-term
mean for 737 months and below its mean for 745 months, and
has crossed its long-term mean six times in the past 25 years,
indicating that the ratio is stationary and reliably mean-reverting.
5
Calculated using the Shiller dataset.
6
The E1/E10 ratio has a weak positive correlation
(+0.10) with future ten-year returns, and is only marginally
significant in explaining returns by itself. The explanatory
power of the variable is brought out when it is used along
with the market E1/P ratio (thus the use of the interaction
term in the model).
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THE JOURNAL OF PORTFOLIO MANAGEMENT 101