My prior post explored the ninth wonder of the world: reversion to the mean. Today, we continue the discussion on this phenomenon.
Forecasting stock returns is a more difficult task than forecasting bond returns. While the relationship only holds at long horizons, what we do know is that valuation metrics such as P/E ratios have had an inverse and mean-reverting relationship with future stock market returns. However, even over 10-year periods, P/E ratios explain only about 40 percent of the time variation in net-of-inflation returns. This is true whether or not trailing earnings are smoothed or cyclically adjusted (as is done in Robert Shiller’s popular CAPE 10 ratio). With that said, you can see the relationship, and the tendency for returns and valuations to mean revert.