P|E changes: some new results

The P|E ratio is often used as a metric to compare individual stocks and the market as a whole relative to historical valuations. We examine the factors that affect changes in the inverse of the P|E ratio (E|P) over time in the broad market (S&P 500 Index). Our model includes variables that measure investor beliefs and changes in tax rates and shows that these variables are important factors affecting the P|E ratio. We extend prior work by correcting for the presence of a long-run relation between variables included in the model. As frequently conjectured, changes in the P|E ratio have predictive power. Our model explains a large portion of the variation in E|P and accurately predicts the future direction of E|P, particularly when predicted changes in E|P are large or provide a consistent signal over more than one quarter. Copyright © 2008 John Wiley & Sons, Ltd.