Menu
in

CAPE: A critical analysis of its predictive power in modern markets

The cyclically adjusted price-to-earnings ratio (CAPE), a brainchild of economist Robert Shiller, has recently hit some eye-popping levels, reaching heights we haven’t seen often in the 21st century. It begs the question: should this metric shape your investment game plan? While CAPE has a knack for hinting at future equity market performance, it’s crucial to understand its limitations as a market-timing tool.

Putting CAPE in Perspective

In my Deutsche Bank experience, I’ve noticed that CAPE has trended without a clear direction for most of its existence since 1900. Historically, when CAPE goes up, a correction or contraction often follows. This pattern suggests that high CAPE values could be a precursor to periods of lower CAPE, which might signal lackluster equity market returns. The numbers speak clearly: CAPE shows a strong negative correlation with future returns, clocking in at -0.7 over ten years, and -0.3 over twenty years. These figures illustrate a consistent trend: an expanding CAPE frequently leads to a contracting CAPE.

Yet, with CAPE currently soaring, we should ask ourselves: how stable is this metric? My analysis leans toward the notion that CAPE might not be a stationary variable and could resist the familiar pull of mean reversion. This insight comes from a detailed study I delved into published in the Journal of Portfolio Management, where I examined CAPE’s journey through time. The looming question is: if the price-to-earnings growth rate keeps climbing, what does that mean for impending market corrections?

Diving Deeper: Technical Analysis and Statistical Insights

To fully appreciate CAPE’s implications, we need to consider whether anything significant shifted in the 1990s. Statistical examinations, like the Quandt Likelihood Ratio (QLR) test, can help pinpoint changes in CAPE’s historical behavior. Analyzing data spanning from 1980 to 1999, my findings suggest that a crucial turning point in CAPE’s behavior likely occurred in August 1991, aligning with notable shifts in market dynamics.

Looking at CAPE’s mean reversion patterns reveals another layer of complexity. Before 1991, negative serial correlation in CAPE changes indicated a tendency to revert to mean values. However, post-1991 data shows a marked decline in this negative correlation, challenging the idea of mean reversion. In simpler terms, prior to 1991, a high CAPE often led to a decline, but this relationship weakened significantly afterward, as demonstrated by a change in coefficients from -0.19 to -0.06.

Regulatory Considerations and Future Insights

The implications of these observations stretch beyond mere statistics; they provoke questions about how markets might behave moving forward and the ongoing relevance of historical CAPE metrics. Since the 1990s, CAPE has consistently hovered above its long-term average, prompting practitioners to confront the unsettling connection between elevated CAPE values and diminished expected returns. While historical patterns can be useful, they may not hold water if the underlying dynamics are shifting.

In conclusion, today’s high CAPE levels should encourage investors to ponder whether this metric will continue to mirror past behavior or if we’ve entered a new phase altogether. The investment landscape is constantly evolving, and as industry professionals, it’s vital to stay alert and flexible in the face of change. Will CAPE revert to its historical norms, or will it continue on its upward path? This remains an open question—one that could significantly impact market strategies in the years ahead.