King of the Mountain: Shiller P/E and Macroeconomic Conditions

Abstract

Contrary to naive expectations, we find that moderate rather than rock-bottom levels of inflation and real interest rates are associated with lofty valuation multiples. Moderate levels create a valuation “mountain,” which is evident not only in the U.S. stock market but in the stock markets of other developed countries. In addition to confirming the evidence presented by Leibowitz and Bova (2007) that P/Es tend to fall in times of both unusually low and high real interest rates, our work suggests a similar linkage between P/Es and inflation. We also study the mean-reversion properties of Shiller P/Es conditioned on real yields and inflation rates. If we assume that P/Es revert toward the levels thus suggested by macroeconomic conditions, we achieve far better forecasts of both long-term and short-term market returns than if we assume reversion toward the long-term historical mean. Our findings suggest new and interesting insights for monetary policy as well as valuation models.