A Closer Look at CAPE Ratio

When estimating returns, we know that current valuations provide valuable information.

The earnings yield derived from the Shiller CAPE 10—the cyclically adjusted price-to-earnings ratio—is considered by many to be at least as good, if not better, than other metrics. It uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle.

The research shows that valuation metrics such as the CAPE 10 explain about 40 percent of real (after inflation) 10-year returns. However, it’s also important to note that the CAPE 10 provides no value forecasting short-term returns. In fact, the correlation with one-year-ahead returns is close to zero.

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