P/E10 and Future Stock Returns

From CXO Advisory Group:

A reader asked: "Have you looked at P/E10 as to the value of the markets?" The definitive P/E10 is perhaps that implied by the publicly available Robert Shiller data set, which calculates P/E10 monthly as 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. Inflation adjustments approximately cancel in this calculation. To test the predictive power and usefulness of P/E10, we employ regression, ranking and cumulative value tests. Using the monthly value of P/E10 and the level of the S&P Composite Index as calculated by Robert Shiller over the period January 1881 through August 2009, we find that...

The following scatter plot relates the 10-year future return for the S&P Composite Index to initial P/E10 using monthly data over the entire sample period (through August 1999 as constrained by the future return calculation). In general, the higher the P/E10, the lower the 10-year future return. The Pearson correlation for the relationship is -0.38, and the R-squared statistic is 0.15, indicating that variation in P/E10 explains 15% of 10-year future returns.

Given the large number of low and negative 10-year returns at fairly low values of P/E10, it appears that using P/E10 as a valuation indicator does not preclude poor outcomes....MUCH MORE