The P-E Ratio, the Business Cycle, and Timing the Stock Market

Abstract

Using monthly stock-market data covering 1871-2020, this paper analyzes how the P-E ratio is related with the future stock-market performance and whether mispricing produces opportunities to time the stock market. The P-E ratio is found to be inversely related with the future stock market performance measured by a realized equity premium. The P-E ratio also shows a positive relationship with stock-market fundamentals measured by a fair P-E ratio. These findings suggest that the P-E ratio may reflect both misguided market sentiment and rational expectations of investors. The cyclically adjusted P-E ratio seems to better reflect mispricing, while the conventional P-E ratio better reflects market fundamentals. Mispricing indicated by the P-E ratio does not appear to be significant and systematic enough to produce clear market-timing opportunities. Timing the stock market based on the business cycle, however, appears to be quite lucrative potentially. Typically, stock prices plunge shortly before or during recession and quickly rebound over the next 2 years or so, creating opportunities to time the market. The potential profit is large, although realizing the profit may involve some complexities related to recession forecasting and tax management. It seems to be a major challenge to explain the overreaction of the stock market to recession within the context of market efficiency.