Improving U.S. Stock Return Forecasts: A “Fair-Value” CAPE Approach

Abstract

The accuracy of U.S. stock return forecasts based on the cyclically-adjusted P/E (CAPE) ratio has deteriorated since 1985. A primary reason has been that traditional CAPE regressions assume the CAPE ratio reverts mechanically to its long-run average, regardless of the macroeconomic environment. In this article, the authors propose an enhancement to standard CAPE-based forecasts that conditions mean reversion in the CAPE ratio on real (not nominal) bond yields, expected inflation rates, and financial volatility in a VAR model. The forecasted results are promising for both real and nominal returns, with out-of-sample forecast errors approximately 50% lower than traditional approaches. The differences are economically meaningful and statistically significant over the forecast period examined. 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, the model proposed by the author predicts nominal U.S. stock returns centered near 5% over the next decade.