25 Pages Posted: 10 Jun 2017 Last revised: 8 Jul 2017
Date Written: July 7, 2017
The accuracy of U.S. stock return forecasts based on the cyclically-adjusted P/E (CAPE) ratio has deteriorated since 1985. The issue is not the CAPE ratio, but CAPE regressions that assume it reverts mechanically to its long-run average. Our approach conditions mean reversion in the CAPE ratio on real (not nominal) bond yields, reducing out-of-sample forecast errors by as much as 50%. At present, low real bond yields imply low real earnings yields and an above-average “fair-value” CAPE ratio. Nevertheless, with Shiller’s CAPE ratio now well above its fair value, our model predicts muted U.S. stock returns over the next decade. We believe that our framework should be adopted by the investment profession when forecasting stock returns for strategic asset allocation.
Keywords: Stock returns, return predictability, CAPE ratio
JEL Classification: G10, C58, E37
Suggested Citation: Suggested Citation
Davis, Joseph H. and Aliaga-Diaz, Roger A and Ahluwalia, Harshdeep and Tolani, Ravi, Improving U.S. Stock Return Forecasts: A 'Fair-Value' Cape Approach (July 7, 2017). Available at SSRN: https://ssrn.com/abstract=2983860