CAPE Mean Reversion, Long-Horizon Returns, and a Moving Valuation Baseline

Summary

This summary of a Haitong Securities study examines whether the cyclically adjusted price-to-earnings ratio can predict long-run US equity returns. Historically, high CAPE readings tended to accompany weaker subsequent ten-year returns, and low readings tended to accompany stronger ones. The analysis argues that this relationship weakened out of sample from the mid-1980s, with CAPE-based forecasts falling below realized returns from the late 1990s onward. It also reports that average CAPE rose substantially after the late 1980s, which challenges the assumption of a fixed valuation mean.

The proposed explanation links valuation levels to real bond yields, expected growth, and monetary conditions. The forecasting approach decomposes future ten-year returns into dividend yield, average earnings growth, and valuation change, using a vector autoregression that includes earnings yield. Allowing the valuation baseline to move with macroeconomic conditions reportedly tracks realized returns more closely than a fixed-mean approach. This is a summary rather than the full study, and it flags model specification and major changes in growth or policy as risks.

Key ideas

• CAPE has historically shown a relationship between current valuation and subsequent ten-year US equity returns.
• The study summary reports that CAPE's out-of-sample forecasting accuracy weakened from the mid-1980s.
• It attributes a higher valuation baseline partly to lower real bond yields and changing macroeconomic conditions.
• The return decomposition combines dividend yield, average earnings growth, and valuation change.
• A valuation baseline that moves with macro conditions reportedly tracks realized returns better, but remains exposed to model and macroeconomic risk.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.