Volatility of Price–Earnings Ratio and Long‐Run Return Predictability

ABSTRACT We introduce a novel second‐order dynamic price–earnings ratio model and demonstrate that both the level and volatility of the price–earnings ratio serve as optimal forecasts of future returns and cash‐flow growth. We show that the volatility of the price–earnings ratio positively predicts future stock returns with both statistical and economic significance, in various horizons and frequencies, and both in‐sample and out‐of‐sample. The volatility of the price–earnings ratio outperforms both the level of the price–earnings ratio and market volatility in predicting returns. Additionally, we find that the volatility of the price–earnings ratio significantly and negatively predicts future macroeconomic growth.