"Rational Pessimism: Predicting Equity Returns by Tobin's q and Price/Earnings Ratios"

In the spring of 2000, two books predicted a substantial fall in the S&P500 Index. Robert Shiller’s Irrational Exuberance found that, historically, a high price earnings ratio, with real earnings averaged over 10 years, accurately predicts a low real rate of return from investing in the S&P500 Index. Smithers and Wright’s Valuing Wall Street found that a high Tobin’s q for the non- financial equities in the S&P500 does the same. We discover that q beats all variants of the PE ratio for predicting real rates of return over alternative horizons. We also formalize the feedback mechanisms considered in both books.

Duke Scholars

Author Edward Tower Economics