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Will the valuation ratios revert to their historical means? Some evidence from breakpoint tests

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  • John B. Carlson
  • Eduard A. Pelz
  • Mark Wohar

Abstract

If valuation ratios return to their historical means any time soon, then equity prices must fall substantially, or earnings and dividends must accelerate sharply, or some combination of these events must occur. Historical patterns over the past century suggest that stock prices will fall to align valuation ratios with their means. Of course, the means of the valuation ratios could have changed. To assess the likelihood of such changes, the authors employ breakpoint tests, which allow for multiple breakpoints at unknown break dates. The authors also review alternative explanations for changes in the ratios. They conclude that although no single explanation may be convincing by itself, taken in toto with empirical evidence of structural change, the preponderance of evidence suggests that the mean of the dividend-price ratio is now somewhere between 1% and 2%, probably nearer to 1%. They also conclude that the mean price-to-earnings ratio is now somewhere between 20 and 25, perhaps even higher.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0113.

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Date of creation: 2001
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Handle: RePEc:fip:fedcwp:0113

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Keywords: Stock - Prices;

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References

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  1. Ellen R. McGrattan & Edward C. Prescott, 2001. "Is the Stock Market Overvalued?," NBER Working Papers 8077, National Bureau of Economic Research, Inc.
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  7. Robert E. Hall, 2001. "Struggling to Understand the Stock Market," American Economic Review, American Economic Association, vol. 91(2), pages 1-11, May.
  8. Jean Helwege & David Laster & Kevin Cole, 1995. "Stock market valuation indicators: is this time different?," Research Paper 9520, Federal Reserve Bank of New York.
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  10. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
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  12. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Cowles Foundation Discussion Papers 719R, Cowles Foundation for Research in Economics, Yale University.
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  16. Jushan Bai & Pierre Perron, 2003. "Computation and analysis of multiple structural change models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 18(1), pages 1-22.
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  18. Bai, Jushan, 1997. "Estimating Multiple Breaks One at a Time," Econometric Theory, Cambridge University Press, vol. 13(03), pages 315-352, June.
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Cited by:
  1. Andrew Vivian, 2007. "The Equity Premium: 100 Years of Empirical Evidence from the UK," CRIEFF Discussion Papers 0711, Centre for Research into Industry, Enterprise, Finance and the Firm.
  2. GIOT, Pierre & PETITJEAN, Mikael, 2006. "The information content of the Bond-Equity Yield Ratio: better than a random walk?," CORE Discussion Papers 2006089, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  3. Andrew Vivian, 2005. "The Equity Premium: 101 years of Empirical Evidence from the UK," Money Macro and Finance (MMF) Research Group Conference 2005 92, Money Macro and Finance Research Group.
  4. Anne Vila Wetherilt & Simon Wells, 2004. "Long-horizon equity return predictability: some new evidence for the United Kingdom," Bank of England working papers 244, Bank of England.

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