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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
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Handle: RePEc:fip:fedcwp:0113
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  1. Steven A. Sharpe, 1999. "Stock prices, expected returns, and inflation," Finance and Economics Discussion Series 1999-02, Board of Governors of the Federal Reserve System (U.S.).
  2. 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.
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  7. John B. Carlson & Eduard A. Pelz, 2000. "Investor expectations and fundamentals: disappointment ahead?," Economic Commentary, Federal Reserve Bank of Cleveland, issue May.
  8. Campbell, John & Shiller, Robert, 1988. "Stock Prices, Earnings, and Expected Dividends," Scholarly Articles 3224293, Harvard University Department of Economics.
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  13. repec:cup:etheor:v:13:y:1997:i:3:p:315-52 is not listed on IDEAS
  14. 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.
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