Valuation Ratios and the Long-Run Stock Market Outlook

Valuation Ratios and the Long-Run Stock Market Outlook -...

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Valuation Ratios and the Long-Run Stock Market Outlook: An Update By John Y. Campbell and Robert J. Shiller March 2001 COWLES FOUNDATION DISCUSSION PAPER NO. 1295 COWLES FOUNDATION FOR RESEARCH IN ECONOMICS YALE UNIVERSITY Box 208281 New Haven, Connecticut 06520-8281 http://cowles.econ.yale.edu/
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1 Valuation Ratios and the Long-Run Stock Market Outlook: An Update 1 John Y. Campbell and Robert J. Shiller 2 Abstract. The use of price–earnings ratios and dividend-price ratios as forecasting variables for the stock market is examined using aggregate annual US data 1871 to 2000 and aggregate quarterly data for twelve countries since 1970. Various simple efficient-markets models of financial markets imply that these ratios should be useful in forecasting future divi- dend growth, future earnings growth, or future productivity growth. We conclude that, overall, the ratios do poorly in forecasting any of these. Rather, the ratios appear to be useful primarily in forecasting future stock price changes, contrary to the simple efficient-markets models. This paper is an update of our earlier paper (1998), to take account of the remarkable behavior of the stock market in the closing years of the twentieth century. Keywords: Stock market, price–earnings ratio, forecasts, expectations, dividend– JEL Classification: G12 When stock market valuation ratios are at extreme levels by historical standards, as dividend–price and price–earnings ratios have been for some years in the US, one naturally wonders what this means for the stock market outlook. It seems reasonable to suspect that prices are not likely ever to drift too far from their normal levels relative to indicators of fundamental value, such as dividends or earnings. Thus it seems natural to give at least some weight to the simple mean-reversion theory that when stock prices are very high relative to these indicators, as they have been recently, then prices will eventually fall in the future to bring the ratios back to more normal historical levels. The 1 This article is based on our joint testimony before the Board of Governors of the Federal Reserve System, December 3, 1996, on material circulated in Shiller (1996) and on Campbell and Shiller (1998). 2 Department of Economics, Harvard University, Littauer Center 213, Cambridge, MA 02138, 617- 496-6448, [email protected]; and Cowles Foundation for Research in Economics, Yale University, 30 Hillhouse Avenue, New Haven, CT 06520, 203-432-3708, [email protected] We acknowledge the able research assistance of Elena Ranguelova and Daniel Waldman, help with data from Robert J. Gordon, and the helpful comments of Paul Samuelson.
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2 idea that they should do so seems intuitive and basic. Metaphorically, when one is moun- taineering, one can enjoy the exhilarating view from high up on a mountain, and may look forward to the possibility of discovering a way up to a much higher level. But one
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This note was uploaded on 12/04/2011 for the course ECON 001 taught by Professor Tnaga during the Spring '11 term at Abant İzzet Baysal University.

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Valuation Ratios and the Long-Run Stock Market Outlook -...

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