Rational Pessimism: Predicting Equity Returns using Tobin's q and Price/Earnings Ratios

In the spring of 2000, two books predicted a substantial fall in the S&P500 Index. Robert Shiller's <I>Irrational Exuberance</I> found that, historically, a high price earnings ratio, with real earnings averaged over 10 years, accurately predicts a low real rate of return from investing in the S&P500 Index. Smithers and Wright's <I>Valuing Wall Street</I> found that a high Tobin's <b><I>q</b></I> for the non-financial equities in the S&P500 does the same. We discover that <b><I>q</b></I> beats all variants of the PE ratio for predicting real rates of return over alternative horizons. We also formalize the feedback mechanisms considered in both books.