Proxying for Expected Returns with Price Earnings Ratios

Long-run regression models using the trailing earnings over price ratio to predict future returns suggested by Campbell and Shiller (1988, 2001) work quite well. However, in this note we show that this variable might result in a downward biased proxy for expected future returns. Instead we suggest using a moving average of the log of 1 plus the earnings price ratio when forecasting long-run returns. The empirical results for the S&P 500 show the superiority of our approach to existing ones.