Economic Fundamentals and Stock Market Valuation: A CAPE-based Approach

Abstract

This paper estimates a fair-value model, based on macroeconomic fundamentals, of the Shiller Cyclically Adjusted Price-to-Earnings (CAPE) ratio. By performing a multi-country analysis, we find that CAPE – a widely used metric for stock market valuations – is, in general, positively related to economic growth and negatively related to the real long-term interest rate and to measures of economic volatility computed using industrial production and inflation data. Empirical evidence arising from predictive regressions of real stock market returns indicates that deviations of CAPE from its estimated fair value are negatively related to future stock returns. A prediction model based on these deviations outperforms, in many cases, a model based on the CAPE levels both in sample and out of sample.

Keywords: stock market valuation, CAPE, macroeconomic fundamentals, macroeconomic volatility, return predictability

JEL Classification: E44, G12