Modelling the Shiller CAPE Ratio, Mean Reversion, and Return Forecasts

Abstract

The Shiller cyclically adjusted price/earnings (CAPE) ratio has yielded overly pessimistic equity return forecasts for two decades, and there is a growing consensus that the CAPE ratio needs to be adjusted for the state of the economy to obtain accurate forecasts. Expanding the literature, the author provides an economic model that explains more than 90% of the CAPE ratio’s variability. A link between the economy and CAPE is useful in investment practice. First, the author’s model shows which economic variables are most important in driving the CAPE ratio and thus equity returns. Second, a fair-value estimate of the CAPE ratio allows a continuous assessment of whether the stock market is in line with economic fundamentals. Third, the model generates equity return forecasts that are consistent with a practitioner’s economic scenario or any alternative scenario such as economic recession. Finally, the author demonstrates that the CAPE ratio is not mean reverting but shows nevertheless how to obtain useful forecasts for horizons of three to four years.

TOPICS: Accounting and ratio analysis, simulations, statistical methods, volatility measures

Key Findings

• ▪ We provide an estimate of the Shiller cyclically adjusted price/earnings (CAPE) ratio based on economic variables. Our estimate explains more than 90% of the CAPE ratio’s variability in the past six decades.

• ▪ The conditions for the Shiller CAPE ratio to be mean reverting are not generally met. Notably, inflation, which is an important factor explaining the level and trend of the CAPE ratio, cannot be assumed to be mean reverting.

• ▪ For practitioners, our model provides a fair-value estimate of the stock market at any point in time, allows simulations (e.g., of expected returns under a recession scenario), and yields useful forecasts for horizons of three to four years.