CAPE is a Very Noisy Market Predictor

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Analysts have many ways to estimate expected market returns. The challenge is to identify those few that provide usable information for making investment decisions. In this article, I discuss one of the common mistakes made in this type of analysis and why the cyclically adjusted PE (CAPE), developed by Robert Shiller, is not nearly as reliable a predictor of market returns as most claim it to be.


One of the best known of these measures is the CAPE. It is widely accepted as an indicator of market under- and over-valuation, no doubt due to its fundamental intuitive appeal. As an example of its wide acceptance, many market commentators are warning that the market is overvalued at the current CAPE of roughly 30 and thus are forecasting low returns.

For any such measure to be useful for making investment decisions, we first need to determine if it has been a reliable predictor of future market returns. As an example of this type of testing, a recent Advisor Perspectives (AP) article examined CAPE’s ability to predict 10-year stock market returns and found that its accuracy was “remarkable.” This anointed CAPE as an excellent candidate for making portfolio decisions.

Unfortunately, the author made the mistake of regressing 10-year overlapping returns on monthly values of CAPE to reach this conclusion. The misuse of overlapping returns is such a common and critical error that it is worth looking more closely at why it is mistakenly used so often, along with the problems it creates. Later in this article I will discuss how you can correctly use CAPE in making decisions.