That the equity risk premium is mean-reverting has been amply documented. Bob Shiller, who won the 2013 Nobel Prize, was one of the first economists to explore in depth the phenomenon of mean reversion in time series of market prices. The behavioral interpretation is that investors over-extrapolate recent price movements and news, which then causes overshooting in prices; subsequent earnings growth then disappoints the irrational expectation, which causes reversal in returns.
Two examples will serve to illustrate the pattern. Irrational exuberance experienced during the tech bubble drove the Shiller P/E to a breathtaking high of 44.2 at the end of 1999, and the stock market return in the subsequent three years was -14.5% per year or -37.5% cumulatively. Fear at the depth of the Global Financial Crisis plunged the Shiller P/E to its lowest level in the last two decades, 13.3 in March 2009; equity returns were 23.5% per year, or 88.5% cumulatively, in the following three years (Table 1). For each month-end from January 1990 to November 2010, Figure 1 shows the cyclically adjusted Shiller P/E ratio and the annualized rate of return for the subsequent three years. (P/E ratios are shown through November 2013.) The chart indicates that, to some extent, rates of return can be predicted on the basis of P/E ratios.