Predicting Stock Market Returns Using the Shiller CAPE — An Improvement Towards Traditional Value Indicators?

Abstract

Existing research indicates that it is possible to forecast potential long-term returns in the S&P 500 for periods of more than 10 years using the cyclically adjusted price-to-earnings ratio (CAPE). This paper concludes that this relationship has also existed internationally in 17 MSCI Country indexes since 1979. In addition, the paper also examines the forecasting ability of price-to-earnings, price-to-cash-flow and price-to-book ratio, as well as that of dividend yield and of CAPE adjusted for changes in payout ratios. The results indicate that only price-to-book ratio and CAPE enable reliable forecasts on subsequent returns and market risks. In countries with structural breaks, price-to-book ratio even exhibits some advantages compared to CAPE.

Based on these findings, the long-term equity market potential for various markets is forecasted using CAPE and price-to-book ratio. The current valuation makes it likely that investors with a global portfolio can achieve real returns of 6% over the next 10 to 15 years. Even greater increases can be expected in European equity markets (8%) and in emerging markets (9%). Due to the high valuation of the US stock market, US investors can only expect below-average returns of 4% with a higher drawdown potential.

Keywords: Shiller PE, CAPE, Asset Allocation, Stock Market Potential, Value Investing, Price-to-Earnings Ratio (PE), Price-to-Book Ratio (PB), Price-to-Cashflow Ratio (PC), Dividend Yield, Payout Adjusted Shiller-CAPE

JEL Classification: E37, G12, G14, G15, G20