Predicting Stock Market Returns Using The Shiller CAPE

Predicting Stock Market Returns Using The Shiller CAPE

Predicting Stock Market Returns Using The Shiller CAPE by StarCapital

Literature on CAPE

Over the past 100 years, US stocks realized real capital gains of 7% per annum. No other asset class — neither bonds, cash, gold nor real estate — provided comparable return potential. Nevertheless, stock markets are subject to very strong fluctuations and the achievable returns depend largely on the time of investment. As such, the question for investors is how they can most accurately forecast long-term stock market developments.

In the case of individual stocks, the fundamental analysis of a company can provide information about potential future returns. Based on the well-established value effect, undervalued stocks realize much greater capital growth than overvalued stocks. However, can this finding be applied to equity markets as a whole?

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The Harvard and Yale professors Campbell and Shiller [1988] were the first to examine this question for the US market. For this purpose, they calculated a price-to-earnings ratio (PE) for the S&P 500 by dividing the value of the index by the aggregate profits of all companies in the index. They found that periods of high market valuation were often followed by years with low returns.

However, the classic PE has two major disadvantages. Firstly, corporate earnings are extremely volatile and, in practice, almost impossible to predict. For example,c fluctuated between 7 and 77 points from 2009 to 2010. Thus, the prevailing level of returns is not necessarily representative of their future development. Furthermore, PEs seem to be particularly unattractive in years of crisis, when low or negative corporate earnings provide lucrative buying opportunities. At such time