Shiller's CAPE: Market Efficiency and Risk
32 Pages Posted: 30 Nov 2016 Last revised: 18 Apr 2017
Date Written: February 7, 2017
Robert Shiller shows that Cyclically Adjusted Price to Earnings Ratio (CAPE) is strongly associated with future long-term stock returns. This result has often been interpreted as evidence of market inefficiency. We present two findings that are contrary to such an interpretation. First, if markets are efficient, returns on average, even when conditional on CAPE, should be higher than the risk-free rate. We find that even when CAPE is in its ninth decile, future 10-year stock returns, on average, are higher than future returns on 10-year U.S. Treasurys. Thus, the results are largely consistent with market efficiency. Only when CAPE is very high, say, CAPE is in the upper half of the tenth decile (CAPE higher than 27.6), future 10-year stock returns, on average, are lower than those on 10-year U.S. Treasurys. Second, we provide a risk-based explanation for the association between CAPE and future stock returns. We find that CAPE and future stock returns are positively associated with future stock market volatility. Overall, (i) CAPE levels do not seem to reflect market inefficiency, and (ii) CAPE levels reflect risk (volatility).
Keywords: CAPE, Stock Market Returns, Returns, Risk Premium, Market Efficiency, Volatility
JEL Classification: G00, G02, G11, G12, G14
Suggested Citation: Suggested Citation