Stock market volatility and fluctuations in the price-earnings ratio

This paper examines the time-series relation between the price-earnings (P/E) multiple and market volatility for the G-7 markets. If investors are risk-averse agents and demand a higher required rate of return to take on more risk, then we should expect P/E to be inversely related to volatility. Using various specifications for volatility and P/E, the relationship is found to be negative and statistically significant across most markets under consideration. This provides indirect evidence that the required rate of return and risk are positively related. These findings also emphasise the importance of considering 'forward-looking' proxies, such as the P/E multiple, when investigating the intertemporal risk-return trade-off.