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Is Irrational Exuberance Over Yet?

Posted in Fundamental Valuation

In the early 2001 update of their 1998 paper entitled “Valuation Ratios and the Long-Run Stock Market Outlook: An Update”, John Campbell and Robert Shiller focus on mean reversion of two valuation ratios, price-earnings and dividend-price, as key predictors of future stock market performance. The authors determine that mean reversions of these ratios occurs through stock price changes, not earnings or dividend changes. At the time of the update, they note that “these ratios imply a stronger case for a poor stock market outlook than has ever been seen before.”

More completely, in their words:

“The very fact that ratios have moved so far outside their historical range poses a challenge however, both to the traditional view that stock prices reflect rational expectations of future cash flows, and to our view that they are substantially driven by mean reversion. Observers of either persuasion must face the fact that something extremely unusual has occurred. In this situation a broad judgment of our position in history, of the uniqueness of recent technological advances and investment patterns, and of the state of market psychology assumes more than usual importance in judging the outlook for the stock market. There is no purely statistical method to resolve finally whether the data indicate that we have entered a new era, invalidating old relations, or whether we are still in a regime where ratios will revert to old levels. In our personal judgment, while we do not expect a complete return to traditional valuation levels, we still interpret the broad variety of evidence as suggesting a poor long-term outlook for the stock market.”

Their most specific prediction:

“Given the low value for the dividend-price ratio at the start of 2000, the regression in the bottom panel of Figure 3 implies a decline of 0.6 in the log real stock price over the next ten years. This corresponds to a 55% loss of real value.”

In summary, mean reversions of fundamental ratios are key predictors of future stock market returns.

From 12/31/99 to 10/9/02, the S&P 500 Composite fell from 1469 to 777 (down 47%). In the two years since, the market has rebounded to 1122, down 24% from 12/31/99. Are we good as new, or still bouncing down toward long-term valuation means?

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