Will Valuation Ratios Revert to Historical Means?

Abstract

Stock market valuation ratios such as dividend-price and price-earnings ratios are at extreme levels by historical standards. Simple mean reversion theory suggests that either equity prices must fall substantially, or earnings and dividends must accelerate sharply, or some combination of these events must happen. Of course, the means of valuation ratios could have changed. To assess the likelihood of means changes, the authors perform break point tests on the means of the valuation ratios and find empirical evidence of breaks. They also review alternative explanations for structural change in the ratios. Although no single explanation may be convincing by itself, when the evidence is taken together with empirical evidence of structural change, the authors conclude that the means have changed. They estimate that the mean of the dividend-price ratio has dropped to somewhere between 1% and 2%, and the mean of the price-earnings ratio has risen to somewhere between 20 and 25, perhaps even higher.