Modified ratios and the cyclically adjusted price-earnings ratio

The simple dividend-price (dp) and earnings-price (ep) ratios for the US stock market econometrically appear to be non-stationary. The contribution of this paper is to propose and study the use of a modified earnings-price ratio (mep) that is a stationary version of the conventional ep ratio. A second contribution is to study the forecasting performance of the modified earnings-price ratio (mep) and modified dividend-price (mdp) alongside the classical ep and dp but also the well-known cyclically adjusted pe ratio (CAPE). In-sample forecasting suggests that the modified ratios have improved nominal return fit over the simple ones. Out-of-sample (OoS), mep provides improvements over the classical ep for nominal return forecasting but no benefit for real returns. CAPE does not seem to generalise well with OoS except for the very long horizon. From an investing perspective, when using the entire sample to estimate the trend correction, one could obtain 27% OoS gain for the 5-year period from the predictive regression with mdp. Over the 7- and 10-year return horizon, the theoretical OoS performance gain through mdp is 60% and 69%, respectively.