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Extrapolating Multiples to Forecast Returns

There are less rigorous methods for predicting the direction of stock prices. Look, for example, at the price level of an equity index like the Standard & Poor's 500. At the depths of the recent market decline in March of 2009, Robert Shiller estimated the p/e ratio for the S&P 500 at about 13.3. The price of the index was measured relative to the trailing 10-year average of the index's quarterly earnings.

See Shiller's site for details.

http://www.econ.yale.edu/shiller/data.htm

Looking back historically, every time the p/e was in this range, the subsequent average 10-year return to the S&P 500 was approximately 8.5 percent since 1926 and 10.5 percent since World War II. At the time this chapter was written, the S&P was trading at about 12× earnings. Historically, when the p/e multiple is within 11× and 13×, subsequent 10-year returns have been 11.8 percent since 1871. These numbers are not meant to be precise, but rather, to illustrate how one could extrapolate from the historical record to forecast forward returns. Thus, one could appeal to the historical record and forecast equity returns moving up into this range over the next decade. While convenient, we must keep in mind that these are long-run return forecasts grounded completely ...