»CAPE in forecasting subsequent returns
›Powerful at forecasting long-horizon returns
›Less so for short-horizon returns
» CAPE and macro regimes
›Link with real interest rate and inflation
›The 3-D valuation mountain
» Application
›Potential of forecasting short-term returns
»Low (high) PE implies high (low) future returns
CAPE vs. Subsequent 10-year Real Returns: January 1990 –June 2015, United States
CAPE vs. Subsequent 10-year Real Returns: January 1990 –June 2015, EM
Relative Valuation Ratios vs Relative Subsequent Returns: January 1990 –June 2015
»High valuation may be justified under the right conditions
The essence of our research: adding one illustrative measure of economic condition to enhance our understanding of the mean-reversion target for CAPE
»Median CAPE plummets when…
›Real interest rate is negative → reflecting a desire to aggressively stimulate the economy, or
›Real interest rate unusually high → reflecting a desire to rein in an overheated economy
Median P/E at Different Real Yield* Regimes (United States, 1880.12–2013.12)
»Median CAPE alsoplummets when…
›Inflation is unusually high → increased money supply without growth
›Inflation is zero or negative → decreased price leads to lower production
Median P/E at Different Inflation* Regimes (United States, 1880.12–2013.12)
Why these results matter? Fed policy intends to depress interest rates for as long as inflation remains low
»Common belief: rock-bottom levels of inflation and real interest rates
»3-D valuation mountain: moderate levels of inflation and real interest rates
Median P/E at Different Inflation and Real Yield Regimes (United States, 1880.12–2013.12)
»Polynomials are simple, but are not bounded
»Gaussian function is a better alternative
»The “sweet spot” for CAPE in U.S. equity market
›Low inflation (~1.5%)
›Moderate real interest rate (~3%)
»Traditional OLS has poor fit(and occasionally wrong sign)
»Gaussian model(3-D Mountain) has an R2 of 50.7%
»CAPE is more powerful in forecasting long-horizon returns
»Adjusted CAPE enhances short-term return forecast
»CAPE is a strong predictor for long-horizon (5-10 years) returns
›Long-term valuations mean-revert, with high statistical significance
»CAPE is a weak predictor for short-horizon (up to 3 years) returns
›Current macroeconomic environment affects normal CAPE
›Provides better estimate of fair market valuation
›Leads to better ability to forecast returns at short-horizon
›Improves results shorter than 3 years in U.S.
›Current CAPE does not matter, except relative to model CAPE
»Transitioning from short to long horizon
›Usefulness of “current” macroeconomic variables fades
›The macroeconomic environment in 5-10 years will differ from today
»Remarkable similarity to what we observe in U.S. equity market
Median P/E at Different Real Yield* Regimes (Developed Countries, 1972.03–2013.12)
»Weaker mountain-shaped relationship due to fewer episodes of very low inflation in the international sample
Median P/E at Different Inflation* Regimes (Developed Countries, 1972.03–2013.12)
»Common belief: rock-bottom levels of inflation and real interest rates
»3-D valuation mountain: moderate levels of inflation and real interest rates
Median P/E at Different Inflation and Real Yield Regimes (Developed Countries, 1972.03–2013.12)
Developed Countries (excluding U.S.), 1972.03–2013.12
»Near-identical location of the “Sweet Spot”
Developed Countries (excluding U.S.), 1972.03–2013.12
»Near-identical location of the “Sweet Spot”
»Few episodes of low inflation:good fit with inflation regression
»Gaussian model(3-D Mountain) has an R2 of 29.9%
Statistical Fit of Various Models Used to Explain P/E (Developed Countries, 1972.03–2013.12)
»Similar to the U.S sample
»Significant increase in forecasting power at short horizons
»Understanding CAPE in a more comprehensive way
›A 3-D valuation mountain better describe fair value of CAPE
»Finding the ―Sweet Spotâ€- for Equity Market Valuations
›Stock prices can be high under the right condition
›Moderate inflation and real interest rate are ideal
›Today’s conditions are not in that sweet spot, but QE is arguably a special kind of easy money, perhaps fueling asset bubbles.
»Application of the 3-D mountain valuation model
›Valuations matter –not just in the long term, but in the short term
›Incorporating macroeconomics conditions significantly increases short-term return forecasting power
»If current real rates were natural, not a consequence of QE
»… and, if the resulting real bond yields were natural
›The natural valuation levels would be lower than today, by a wide margin.
»What are the ideal macroeconomic conditions for a soaring CAPE?
›Common belief: rock-bottom levels of inflation and real interest rates
›3-D valuation mountain: moderate levels of inflation and real interest rates
Median P/E at Different Inflation and Real Yield Regimes (United States, 1880.12–2013.12)
Median P/E at Different Inflation and Real Yield Regimes (Developed Countries, 1972.03–2013.12)
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