P/E changes: some new results

The P/E ratio is often used as a metric to compare individual stocks and the market as a whole relative to historical valuations. We examine the factors that affect changes in the inverse of the P/E ratio (E/P) over time in the broad market (S&P 500 Index). Our model includes variables that measure investor beliefs and changes in tax rates and shows that these variables are important factors affecting the P/E ratio. We extend prior work by correcting for the presence of a long-run relation between variables included in the model. As frequently conjectured, changes in the P/E ratio have predictive power. Our model explains a large portion of the variation in E/P and accurately predicts the future direction of E/P, particularly when predicted changes in E/P are large or provide a consistent signal over more than one quarter.