Can The CAPE Ratio Predict Stock Market Returns? (Rules, Strategy, Statistics)

There are many ways investors try to determine if the stock market is overvalued or not. Some people rely on technical indicators to gauge whether the market is overextended or overbought, while others employ valuation measures like the P/E ratio, P/B ratio, or the CAPE ratio.

Yes, based on empirical data, The CAPE Ratio predicts future stock market returns.

The Cyclically Adjusted Price Earnings (CAPE) ratio is a valuation multiple commonly used to value the stock market. This is because it takes the last 10-year earnings average rather than the TTM earnings, thus avoiding periods of significant volatility.

In this article, we will look at the CAPE ratio and build some forecasting models to see whether the level of the CAPE ratio can predict future stock returns.

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What is the CAPE ratio?

The CAPE ratio, also known as the Shiller P/E ratio, is a valuation measure that uses real earnings per share over a 10-year period to smooth out fluctuations in corporate profits.

It was developed by Robert Shiller, a distinguished business professor from Yale University and Nobel Laureate and it has become a significant indicator frequently used by the media or pundits.

Here is how the US CAPE ratio has evolved for US stocks over the last 40+ years (taken from Shiller’s webpage):

What is the CAPE ratio?

Many articles and papers have researched the relationship between the CAPE ratio and future returns. The idea is that a lower CAPE ratio means higher stock returns in the future and vice versa. We decided to put this theory to the test and do some backtests. 

Can the CAPE ratio predict stock market returns?

This seems like a simple question, but the answer depends on the timeframe.

Can the CAPE ratio predict how the market will perform next year? The short answer is no.

The next chart shows the CAPE ratio and subsequent 1-year CAGR of US stocks (S&P 500 not adjusted for dividends): 

Predicting Stocks Future Returns With The CAPE Ratio

As you can see, in the short term, the level of the CAPE ratio can’t tell us much about how the stock will perform in the near future. Even though the slope is slightly positive, the dispersion is too high.

But what happens if we increase the timeframe to 5 years?

CAPE ratio and subsequent 5 year returns

This chart looks better. Although the 20-30 range shows a lot of dispersion, it is more significant compared to a one-year horizon. When the CAPE ratio is high, we can expect low future returns and vice versa.

It seems that as we increment the time frame, the results get better. So what about 10 years?

CAPE ratio and subsequent 10 year returns

The longer the time frame, the more negative the relationship. Now we can observe a clear relationship between the CAPE level and the future 10-year CAGR.

As of June 30th, 2023, the US stocks’ CAPE ratio is just under 31. This means that we should expect stocks to compound money at a 6-4% CAGR over the next ten years (without taking into account dividends).

However, there are some criticisms made of this type of forecasting. The main one is that it doesn’t consider changes in the GAAP accounting rules, which have been made in recent years.

Another critique is that the number of observations is low. High and low valuations don’t happen often.

Can The CAPE Ratio Predict Stock Market Returns? Conclusion

To sum up, we learned that the CAPE ratio seems to predict future stock returns over a long time frame of 5 years or more. Despite its criticism, it might be an effective tool when allocating capital to stock for the long term.

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