King Of The Mountain: Finding Short-Term Efficacy In The CAPE Ratio by Rob Arnott, Research Affiliates

King of the Mountain

  • CAPE ratio in forecasting subsequent returns
    • Powerful at forecasting long-horizon returns
    • Less so for short-horizon returns
  • CAPE and macro regimes
    • Link with real interest rate and inflation
    • The 3-D valuation mountain
  • Application
    • Potential of forecasting short-term returns

CAPE Ratio in forecasting subsequent returns

Valuation Ratios Mean Revert at Long-Horizon

  • Low (high) PE implies high (low) future returns

CAPE Ratio

High Stock Valuations Produce Lower Returns

CAPE Ratio

Same Relationship in EM Equities

CAPE Ratio

EM Risk is Priced Again

CAPE Ratio

CAPE is Powerful at Forecasting Long-Horizon Returns, Less So for Short-Horizon Returns

CAPE Ratio

CAPE Ratio

CAPE Ratio

CAPE Ratio and Macro Regimes

Link Between CAPE and Real Interest Rates

  • Median CAPE plummets when…
    • Real interest rate is negative -> reflecting a desire to aggressively stimulate the economy, or
    • Real interest rate unusually high -> reflecting a desire to rein in an overheated economy

CAPE Ratio

Link Between CAPE and Inflation

  • Median CAPE also plummets when…
    • Inflation is unusually high -> increased money supply without growth
    • Inflation is zero or negative -> decreased price leads to lower production

CAPE Ratio

Why these results matter? Fed policy intends to depress interest rates for as long as inflation remains low.

The Macroeconomic Sweet Spot for A Soaring CAPE

  • Common belief: rock-bottom levels of inflation and real interest rates
  • 3-D valuation mountain: moderate levels of inflation and real interest rates

CAPE Ratio

Use Gaussian Model to Fit a Continuous Function

  • Polynomials are simple, but are not bounded
  • Gaussian function is a better alternative

CAPE Ratio

  • Seven parameters are found by minimizing the weighted* sum of squared errors on a 10 x 10 grid

CAPE Ratio

Gaussian Model – Surface Curves

  • The – sweet spot? for CAPE Ratio in U.S. equity market
    • Low inflation (~1.5%)
    • Moderate real interest rate (~3%)

CAPE Ratio

Application: Improving Return Forecasts

Forecasting Returns with CAPE and Modeled CAPE United States, 1880.12–2013.12

  • CAPE is more powerful in forecasting long-horizon returns
  • Adjusted CAPE enhances short-term return forecast

CAPE Ratio

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