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

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

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

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Date of creation: 2001
Date of revision:
Handle: RePEc:fip:fedcwp:0113
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  1. Campbell, John & Shiller, Robert, 1988. "Stock Prices, Earnings, and Expected Dividends," Scholarly Articles 3224293, Harvard University Department of Economics.
  2. Martin Feldstein, 1978. "Inflation and the Stock Market," NBER Working Papers 0276, National Bureau of Economic Research, Inc.
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  4. 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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  6. Ellen R. McGrattan & Edward C. Prescott, 2000. "Is the stock market overvalued?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40.
  7. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  8. 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.
  9. John Y. Campbell & Robert J. Shiller, 2001. "Valuation Ratios and the Long-run Stock Market Outlook: An Update," Cowles Foundation Discussion Papers 1295, Cowles Foundation for Research in Economics, Yale University.
  10. Jean Helwege & David Laster & Kevin Cole, 1995. "Stock market valuation indicators: is this time different?," Research Paper 9520, Federal Reserve Bank of New York.
  11. 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.).
  12. 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.
  13. Jushan Bai, 1995. "Estimating Multiple Breaks One at a Time," Working papers 95-18, Massachusetts Institute of Technology (MIT), Department of Economics.
  14. Nathan S. Balke & Mark E. Wohar, 2002. "Low-Frequency Movements in Stock Prices: A State-Space Decomposition," The Review of Economics and Statistics, MIT Press, vol. 84(4), pages 649-667, November.
  15. Perron, P. & Bai, J., 1995. "Estimating and Testing Linear Models with Multiple Structural Changes," Cahiers de recherche 9552, Universite de Montreal, Departement de sciences economiques.
  16. 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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  18. repec:cup:etheor:v:13:y:1997:i:3:p:315-52 is not listed on IDEAS
  19. 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.
  20. 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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