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
High Stock Valuations Produce Lower Returns
Same Relationship in EM Equities
EM Risk is Priced Again
CAPE is Powerful at Forecasting Long-Horizon Returns, Less So for Short-Horizon Returns
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
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
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
Use Gaussian Model to Fit a Continuous Function
- Polynomials are simple, but are not bounded
- Gaussian function is a better alternative
- Seven parameters are found by minimizing the weighted* sum of squared errors on a 10 x 10 grid
Gaussian Model – Surface Curves
- The – sweet spot? for CAPE Ratio in U.S. equity market
- Low inflation (~1.5%)
- Moderate real interest rate (~3%)
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
See full Slides below.
