In 1998, Robert Shiller and his coauthor John Campbell published a path breaking article,
“Valuation Ratios and the Long-Run Stock Market Outlook.” This article, following up on some
of their earlier work on stock market predictability, established that long-term stock market
returns were not random walks but could be forecast by a valuation measure called the Cyclically Adjusted Price-Earnings ratio, or CAPE ratio.
The CAPE ratio was calculated by taking a broad-based index of stock market prices, such as the S&P 500, and dividing by the average of the last ten years of aggregate earnings, all measured in real terms. The CAPE ratio was then regressed against the future ten year real returns on stocks, establishing that the CAPE ratio was a significant variable predicting long-run stock returns.
The Shiller CAPE Ratio and Forecast and Actual Returns
The predictability of real stock returns implied that long-term equity returns were mean
reverting. In other words, when the CAPE ratio was above its long run average, the model
predicted below-average real returns for stocks over the next decade and the model predicted
above-average returns when the CAPE ratio was below its average.
The CAPE ratio from 1871 through 2012 is plotted in Figure 1 along with the forecast ten-year real stock returns from the model against the actual ten year returns. The CAPE model is able to explain just under one third of the variation in future 10-year real stock returns.
The CAPE ratio gained attention when the authors presented a preliminary version of their
1998 paper at the Board of Governors of the Federal Reserve on December 3, 1996 and warned that stock prices in the late 1990s were running well ahead of earnings. Greenspan’s “Irrational Exuberance Speech,” delivered one week later, was said to have been based, in part, on their research.4 At the top of the bull market in 2000 the CAPE ratio hit an all-time high of 43, more than twice its historical average and correctly forecast the poor equity returns over the next decade.