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In a 2016 paper Jeremy Siegel agrees that the cyclically adjusted price earnings, CAPE, ratio “has served as one of the best forecasting models for long-term future stock returns” but that, in 2015, recent forecasts of future equity returns were, in his reasoned opinion, too pessimistic using the CAPE ratio. (Financial Analysts Journal Vol. 72, 3)
He first looked at the correlation between CAPE and subsequent returns.
The figure shows that if the CAPE is above its long-term average then, generally, we observe below average real (above inflation) share returns over the next ten years.
For example, in December 1999 the US CAPE was more than 44. The model (based on 134 years of data) suggested returns would be around negative 7 – 8% per year over the following decade. In fact, between December 1999 and 2009 average annual negative returns were not quite as bad at around 5 – 6%.
When the CAPE is below its long run average then the model predicts, based on past events, that annual share returns during the following decade will be above average. For example, in 1981 the CAPE was about 10. In the next ten years actual share returns were over 10% per year on average.
CHART
Source: Siegel 2016
Whatever you do, do not take an historical mathematical relationship and expect a precise prediction concerning the future.
Having said that, it seems reasonable to expect that when the CAPE is very high you are likely to observe relatively low share returns in the next decade, even if you can’t say whether that will be -8%, zero or +3%.
We can be pretty sure it will be poor – but not completely sure, given the possibility of overpowering random events occurring.
Doubts about the CAPE calculation in 2015
Siegel points to changes in accounting (GAAP) rules which resulted in a pushing down of corporate earnings numbers compared with what they would be under the old rules, e.g. in mark-to-market accounting.
Accounting practices changed in 1990 resulting in depressed reported earnings during economic downturns to a greater extent than in…… To read the rest of this article, and more like it, subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
