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AspiringRationalist comments on Stupid Questions September 2015 - Less Wrong Discussion
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Do you want a citation for that P/E ratios reflect market expectations about future value (and thus earnings), or do you want a citation for the claim that the market is good at predicting what earnings will be in the future?
The claim that the market is good at predicting future earnings.
It probably is, but economics does not yet have the empirical grounding to give me high confidence in its theories (the way I would be for fields like physics or chemistry; I still think economic theory has a strongly positive correlation with reality).
This is conceptually very easy to test; get historical stock price and earnings data, compute P/E ratios at each snapshot, compute earnings growth across snapshots, and then look at the relationship between the two. Vanguard ran the numbers here (page 7), and two ways of calculating the P/E ratio were the strongest two factors. (As one would expect, 1-year returns were very difficult to predict at all, and they were mostly useful for 10-year returns.)
If I've understood that document correctly, they aren't saying anything about predicting performance of individual companies, they're looking at some sort of averaged P/E ratio and relating it to future performance of the stock market as a whole.
One way for that to work would be for individual stocks' P/E ratio to be indicative of their future performance, but there are others; e.g., maybe overall economic conditions influence both investors' attitudes and future performance. In the latter case, P/E ratio might be less useful (or outright useless) for comparing companies at a single time.
Agreed. I went with the first Google search result that was at all close to the question at hand; I recommend anyone more interested in the subject collect the data and run the numbers themselves.
In particular, one might want to compare residual P/E ratios--that company's P/E minus the S&P 500's P/E or the total stock market P/E--to future earnings growth in order to try to remove some of the time-dependent effects and specifically judge the market's ability to guess the earnings growth of individual companies.
One could, if they knew historical industrial groupings, judge the market's ability to price the overall market, industries, and individual companies. It seems like we would expect the first to be better than the second, which is itself better than the third. This is both for the raw statistical reason that the sample being averaged over is smaller as we go down, making the range of reasonable numbers larger, and the financial reason that forces on larger scales may be more visible or predictable than forces on smaller scales.
That's very useful info. Thanks for the link.