Using Cape to Estimate Future Stock ReturnsUsingCapetoEstimateFutureStockReturns

Recent Wall Street research suggests the prospect of relatively low stock returns over the next decade (e.g., 1%/y real return).¹ This is a significant reduction compared to the prior decade’s realized real return of 10.5%/y.  The prospect of low future returns stems from high stock market valuation as measured by CAPE (Shiller’s S&P 500 cyclically adjusted P/E).  Historically, high levels of CAPE are associated with relatively low long-term future stock returns.  

However, using CAPE to generate future stock return estimates can produce significantly different forecasts depending on how CAPE is specified in the forecast model and whether there are other explanatory variables. While CAPE is viewed as an important predictor of future stock returns, there is little consensus on how to use CAPE for future return estimation.  

We compare various CAPE models and identify that (1/CAPE – R) (i.e., stock earnings yield – 10y US Treasury real yield) – also know as “stock excess yield” or the “Fed Model” – has delivered the best estimation performance (of those models considered), regardless of the level of CAPE.²

(1/CAPE – R) (i.e., stock earnings yield – 10y US Treasury real yield) has been – both theoretically and empirically – the best way to incorporate CAPE in estimating future 10y stock returns, especially when CAPE is high.

Historically, the recent reading of (1/CAPE – R) suggests a 4.6%/y real return for stocks over the next decade (vs. 10.5%/y over the past decade), translating to a 6.6%-7.6%/y nominal return assuming 2%-3%/y inflation.