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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. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
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  6. J. Nellie Liang & Steven A. Sharpe, 1999. "Share repurchases and employee stock options and their implications for S&P 500 share retirements and expected returns," Finance and Economics Discussion Series 1999-59, Board of Governors of the Federal Reserve System (U.S.).
  7. Martin Feldstein, 1983. "Inflation and the Stock Market," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 186-198 National Bureau of Economic Research, Inc.
  8. Donald W.K. Andrews, 1988. "Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation," Cowles Foundation Discussion Papers 877R, Cowles Foundation for Research in Economics, Yale University, revised Jul 1989.
  9. Jushan Bai, 1995. "Estimating Multiple Breaks One at a Time," Working papers 95-18, Massachusetts Institute of Technology (MIT), Department of Economics.
  10. John Heaton & Deborah Lucas, 2000. "Stock Prices and Fundamentals," NBER Chapters, in: NBER Macroeconomics Annual 1999, Volume 14, pages 213-264 National Bureau of Economic Research, Inc.
  11. Nathan S. Balke & Mark E. Wohar, 2001. "Low frequency movements in stock prices: a state space decomposition," Working Papers 0001, Federal Reserve Bank of Dallas.
  12. repec:cup:etheor:v:13:y:1997:i:3:p:315-52 is not listed on IDEAS
  13. Robert E. Hall, 2001. "Struggling to Understand the Stock Market," American Economic Review, American Economic Association, vol. 91(2), pages 1-11, May.
  14. Jean Helwege & David Laster & Kevin Cole, 1995. "Stock market valuation indicators: is this time different?," Research Paper 9520, Federal Reserve Bank of New York.
  15. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Cowles Foundation Discussion Papers 719R, Cowles Foundation for Research in Economics, Yale University.
  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.
  17. Ellen R. McGrattan & Edward C. Prescott, 2000. "Is the stock market overvalued?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40.
  18. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 15(2), pages 457-510.
  19. John Y. Campbell & Robert J. Shiller, 2001. "Valuation Ratios and the Long-Run Stock Market Outlook: An Update," NBER Working Papers 8221, National Bureau of Economic Research, Inc.
  20. John B. Carlson & Eduard A. Pelz, 2000. "Investor expectations and fundamentals: disappointment ahead?," Economic Commentary, Federal Reserve Bank of Cleveland, issue May.
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Cited by:
  1. 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).
  2. 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.
  3. 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.
  4. 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.

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