Star Capital published a research report titled CAPE: Predicting Stock Market Returns last year. Authored by Norbert Keimling, Head of Capital Market Research, the report focuses on Robert Shiller’s cyclically adjusted price to earnings ratio (CAPE), and makes the case that CAPE is a valuable predictive tool for the performance of global stock markets over a 10-15 year horizon.

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The report begins with an overview of the use of price to earnings ratios as an analytical tool, and makes the argument that that “many of the weaknesses of classic P/Es can be eliminated.” Keimling points out that famed economist Robert J. Shiller was able to “prove that inflation adjusted corporate profits have achieved relatively stable growth on the American equity market since 1871 of 1.6% p.a.”

Noting that above-average corporate profits in economic boom years are as short-lived over a long term horizon as big corporate losses during recessions, Shiller created CAPE, which represents the ratio of the current market price to the average inflation-adjusted profits of the previous decade. Keimling notes: “CAPE measures whether the valuation of an equity market is high or low compared with its current profit level – to which it will return in all likelihood.”

A historical look at CAPE in U.S. equity markets

CAPE

With a few exceptions, CAPE moved up and down between 10 and 24 in the American equity market from 1881-2013, but returning again and again to its historical average of 16.5. There were only four occasions in which CAPE traded outside the 10 to 24 range: in 1901, 1928, 1966 and 1996. Keimling highlights that or each of these exceprions, “plausible explanations were given as to why old valuation parameters should no longer be used, e.g. the introduction of mass production, the telephone, the departure from the gold standard, the computer age or globalization. But investors were continually wrong: In each of these years the S&P 500 marked record highs. Investors who invested in these overvaluations regularly incurred real price losses over a period of 15-20 years.”

Although high CAPEs signaled risk historically, lower CAPEs and negative market sentiment were followed by strong capital growth over the net 15 years. Of note, for the S&P 500, CAPE has only dropped below 8 three times: in 1917, 1932 and 1980. In each case, the S&P 500 saw historic lows, but high returns of an averaging 10.5% followed in each of the following 15 year periods.

CAPE and global stock markets

CAPE

It turns out CAPE has also been predictive for the performance of global stock markets. Keimling says his research “confirms this connection in 14 other equity markets in the period 1979-2013. A connection between the CAPE and subsequent long-term equity market returns could be established in all reviewed countries.”

CAPE

In these markets, low CAPE readings of less than 8 were followed by strong real capital growth at an annual average 13.1% over the next 15 years. Even in the most unfavorable case of all 4,083 observation periods, sequential annual returns of a real 5.7% were produced in the following 15 years, with the majority of sequential returns coming in between 10.9% and 14.9%. CAPE readings above 32 also produced almost no capital growth at an average 0.0%. In this case, the sequential returns typically came in between -2.8% and 2.0%.

CAPE

Finally, Keimling notes that based on current CAPEs, European markets, especially the DAX, are likely to outperform U.S. markets over the next 15 years.

See full PDF below.