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12/14/2005
P/Es and Returns, by Victor Niederhoffer

One of the ideas of the day and the fray is that stocks are overvalued because P/Es are too high. The gist is that over the past X years the average P/E is, say, 14 -- but right now it is 20 and therefore they are too high. And if stocks revert to the long-term mean, then that in itself will cause a decline of 30% or so, so get out now.

Of the 22,000 articles I googled and am beginning to examine on this subject, I have not yet found one that uses the relation of  P/Es to returns for anything but a currently bearish forecast. But all these studies are deeply flawed, the main weakness being that they don't use current data, they don't take account of interest rates , they use fictitious data from the early periods, they come from an ideological anti-optimistic bias, they confound results for individual stocks with the market as a whole, they suffer from a misplaced assumption that because a given level is above a retrospective mean, it is likely to fall from its current level, they place undue reliance on the deeply flawed and biased Shiller data and conclusions that five-year returns are inversely correlated with P/E ratios. they contain numerous armchair assumptions usually about the excessive nature of earnings or forecasts that could make reported P/E artificially low.

Most of all, they don't take account of the fact that relative to interest rates, stocks are currently at very low price-to-earnings ratios. And even more important, they don't take the trouble to test, to put pencil to paper as Mr. Downing and I have done, to show that a prospective study of market P/Es, forecasted earnings and current interest rates during the last 25 years shows that a highly accurate forecast of future return is possible. Such a prospective study which I will report on in detail on this site, at my own pace, shows that the current last 12 months' reported P/E of the market relative to actual 10-year interest rates has been highly predictive of future market returns during the last 25 years with a correlation between prediction and actual of the order of 0.3, and that such a variable is quite bullish for the current year.

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