Beware of the Misinterpretations of the CAPE Ratio

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With the Shiller CAPE 10 ratio having risen above 31, more and more investors are becoming worried about both the outlook for future equity returns and the possibility of mean reversion in valuations, which could lead to a bear market.

The concern about future returns is justified by the fact that, while the academic research shows valuations are an extremely poor forecaster of stock returns in the short term, they are the best predictor of long-term returns. A CAPE 10 of 31 translates into a real-return forecast for U.S. stocks of less than 3%. Add in 2 percentage points for expected inflation and you get a nominal return of about 5%, half the size of the historical return. Let’s look at some of the evidence.

In his November 2012 white paper, “An Old Friend: The Stock Market’s Shiller P/E,” Cliff Asness showed that 10-year forward average real returns fall nearly monotonically as starting Shiller CAPE 10 ratios increase.

In addition, as the starting CAPE 10 increases, worst cases get worse and best cases get weaker (the entire distribution of returns shifted to the left). However, there were still very wide dispersions of returns. For example, even when the CAPE 10 ratio was above 25, the best 10-year real return was 6.3%, less than 1 percentage point below the historical average. Such wide dispersions explain why the CAPE 10, while it provides information on future returns, should not be used as a tool to time the markets.