Friday, December 5, 2008

Return to rationality: stocks predicted to yield 6%

In 1996, economists Campbell and Shiller met with Fed Chairman Alan Greenspan to brief him on their research that the stock market was significantly over-valued. Greenspan was impressed enough by their work to give his "irrational exuberance" speech. Christopher Carroll has applied Campbell and Shiller's methodology (P/E ratios computed using a 12 year moving average of earnings) to today's stock market and says that it is just about where it should be.
Some market commentators argue that the recent stock price declines reflect a degree of irrational pessimism or panic that is the inverse of the irrational exuberance of the 1990s. The Campbell and Shiller figure provides no support for that view; the vertical line reflecting the Graham P/E ratio in late October is right around the middle of historical experience, not on the far left end. The intersection of that line with the regression forecast indicates that historical experience would lead one to forecast a historically average return on equities over the next 12 years of about 6 percent or so per year (net of inflation).

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