Practical Applications of Improving U.S. Stock Return Forecasts: A “Fair-Value” CAPE Approach

Practical Applications Summary

In Improving U.S. Stock Return Forecasts: A “Fair-Value” CAPE Approach, published in the Winter 2018 issue of The Journal of Portfolio Management, authors Joseph Davis, Roger Aliaga-Díaz, Harshdeep Ahluwalia (all with the Vanguard Group), and Ravi Tolani (of Duke University) introduce a new method of forecasting equity returns in real time (not in sample) using the cyclically adjusted price-to-earnings(CAPE) ratio. They call the result a “fair-value CAPE model” to distinguish it from traditional approaches that use CAPE ratios to forecast future equity returns.

The authors demonstrate that their fair-value CAPE provides a better tool for forecasting of future stock returns in real time than the original CAPE and its subsequent variants. The new twist in the fair-value CAPE model is the use of bond yields, inflation, and volatility in calculating the ratio. The authors forecast (as of July 2017) that the return on U.S. stocks over a 10-year period would be 4.9%, which is lower than the long-term historical average.