P/E Ratios and Stock Market Returns

Trevino, Ruben; Robertson, Fiona
February 2002
Journal of Financial Planning;Feb2002, Vol. 15 Issue 2, p76
Academic Journal
This article examines the relationship between current P/E ratios and subsequent stock market average returns. The findings indicate that current P/E levels have little correlation with subsequent short-term (less than three years) average returns. However, results suggest that long-term average stock returns (holding periods of more than five years) are lower after investing when P/E ratios are high. Furthermore, even though long-term average stock returns are lower after periods of high P/E ratios, average stock returns are still higher than average returns on Treasury bonds and Treasury bills. By the mid-I990s, years of large increases in stock prices had lifted the market's average P/E well above 20-very high by historical standards. Prices continued to rise, rewarding investors with returns of over 20 percent each year between 1996 and 1999. However, with the start of the new century in March 2000, the Nasdaq lost almost 70 percent of its value in a period of 12 months. In theory one would expect that over the long run, very high P/E ratios cannot be sustained. If this is true, as prices revert to their equilibrium levels, one would expect price declines or more modest price increases. Thus, when P/E ratios are high, returns will tend to be low.


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