Searching for the P/E Mean Reversion Affinity – An Application of the Flexible Fourier Approximation

Abstract

The S&P 500’s Price/Earning mean reversion phenomenon seriously threatens foundations of the efficient market hypothesis. Using the Fourier approximation and regime switching models, the P/E mean reversion issue has been further investigated. The empirical findings of the threshold autoregressive model during 1871:12–2016:3, suggest that the P/E mean reversion tendency can be justified only in an economic expansion during which the P/E ratio stays afloat above its likely long-run threshold. However, the speed of adjustment toward the historical long-run equilibrium is practically non-existent in contractionary periods during which the P/E ratio tends to be below its estimated threshold.