P/E10 and Future Stock Market Returns

Several readers have asked about P/E10 as an indicator of stock market valuation. P/E10, as calculated in Robert Shiller’s data set, is the ratio of the inflation-adjusted S&P Composite Index level to the average monthly inflation-adjusted 12-month trailing earnings of the index companies over the previous ten years. Does this indicator usefully predict future U.S. stock market returns? Is there an optimum range of PE/10? Is a ten-year history of earnings the best averaging interval? To investigate, we employ regression, ranking and cumulative value tests. Using Robert Shiller’s monthly estimates of the nominal and real S&P Composite Index (without dividends) and 12-month trailing real earnings during January 1871 through August 2009, we find that: (more…)