Using Inflation and Real Rates to Improve CAPE-Based Return Forecasts

Summary

The document summarizes research on how macroeconomic conditions relate to cyclically adjusted price earnings ratios and stock returns. CAPE smooths earnings using a long inflation adjusted history, which can make it informative about long horizon returns but less reliable over short horizons. The research described finds that valuation multiples tend to be highest in moderate ranges of inflation and real interest rates. It models this relationship with a two dimensional Gaussian function, then compares current CAPE with the level historically associated with similar macro conditions. The summary reports stronger short term return forecasting in the United States and developed international markets than when comparing CAPE with a single long run average.

The method’s advantage is horizon dependent: current inflation and real rates can improve near term forecasts, while their changing levels make the adjustment less useful for longer forecasts. The document notes limitations from sparse observations in some macroeconomic regimes, cross country accounting differences, and extreme historical episodes such as Japan’s bubble. Its title refers to risk parity, but the supplied material mainly discusses CAPE and macroeconomic valuation; it gives only a brief, separate claim that risk parity results depend on asset selection and bond market history.

Key ideas

• CAPE uses a long inflation adjusted earnings history to reduce the influence of short term profit swings.
• Equity valuation multiples in the described research are highest under moderate inflation and real interest rates.
• Comparing CAPE with a macro condition specific historical level can improve short term return forecasts.
• The macro adjusted approach becomes less reliable over long horizons as inflation and real rates change.
• The document’s risk parity title is only briefly addressed, while most of its analysis concerns CAPE.

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