Predicting Stock Market Returns Using The Shiller CAPE

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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?

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 times, the PE does not take into account the potential for earnings growth after the crisis.


Already in 1934, Graham & Dodd suspected that cyclical fluctuations in earnings could adversely affect the validity of PE. As a result, they recommended using an average of earnings for the last 7 to 10 years to calculate the PE. Following this advice, Campbell and Shiller [1998] developed a cyclically adjusted price-to-earnings ratio (CAPE), which puts the current market price in relation to the average inflation-adjusted profits of the previous 10 years. The purpose of the 10-year observation period is to ensure that the profits are averaged over more than one earnings cycle. The adjustment for inflation ensures the comparability of profits even at times of high inflation. As such, the CAPE measures whether the value of an equity market is high or low compared to its profit level adjusted for an economic cycle — to which it will very likely return.

From 1881 to 2015, the CAPE for the S&P 500 was frequently between 10 and 22, often returning to its historical average of 16.6 (Figure 1). According to Campbell and Shiller [1998], this mean reversion takes place not because of changes in earnings but in prices, thus enabling more reliable long-term return forecasts than the classic PE.

Since 1881, the CAPE of the S&P 500 has significantly exceeded this range only four times: in 1901, 1928, 1966 and 1995. For each of these years, plausible reasons were given for why long-standing methods of evaluation should no longer apply, such as the introduction of mass production, the telephone, the departure from the gold standard, the computer age or globalization. In retrospect, these arguments proved unsound: the S&P 500 marked record highs in each of these years. Investors who invested in these overvaluations generally experienced real losses over periods of 10-20 years.

While high CAPE indicated low returns, attractive CAPE and pessimistic market sentiment led to above-average returns in the long-term. The S&P 500 CAPE has only dropped below the value of 8 three times: in 1917, 1932 and 1980. Each of these years marked historic lows in the S&P 500 — and each time, high real returns of on average 10.5% p.a. followed over the subsequent 15 years.

The relationship between CAPE and subsequent long-term returns is not only visible in the S&P 500. Research by Bunn and Shiller [2014], Keimling [2005] and Klement [2012] suggests that the relationship also exists on a sector level, in other international equity markets and in the emerging markets.

Criticism of the CAPE approach

Criticism of CAPE has increased in recent times as the S&P 500’s CAPE has only fallen below its long-term average of 16.6 in 9 out of 240 months over the past 20 years. Also, the average CAPE of 27.0 since 1995 is around 60% above its long-term average and even at the market’s bottom in March 2003, it never fell below 20. It is particularly relevant to ask the question whether altered payout ratios, new accounting standards or other structural changes limit the comparability of current and historical CAPEs. These points of criticism will be discussed in the following section.

2.1. CAPE criticism I: payout ratios

In the period 1881-1950, S&P 500 companies distributed 65.6% of their earnings in the form of dividends. Since 1990, it has been only 39.4%. The declining payout ratio gives companies greater scope for investments and share buybacks, which could increase EPS growth. Indeed, corporate profits have grown by 2.7% annually since 1990, much more than the 1.0% from 1881 to 1950 (Figure 2).

This is not without consequences for the comparability of CAPE: CAPE evaluates an equity market on the basis of its average earnings during the previous 10 years. The stronger the permanent earnings growth, the further the current level of earnings moves away from the average, which would lead to higher fair CAPE levels. As such, the higher CAPE that we have witnessed since 1990 could be partially explained by a modified dividend policy.

Therefore, Shiller and Bunn [2014] propose an adjusted CAPE to take into account the modified payout ratios. The authors calculate CAPE on the basis of (theoretical) total return EPS, which presumes a payout ratio of 0% — that is total share buybacks. Whether this adjustment does indeed strengthen the position of CAPE in the S&P 500 remains to be seen. Furthermore, the question remains as to whether the adjustment increases the comparability of CAPE among countries with different payout ratios.



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