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The Many Colours of CAPE

Last Updated on 10 February, 2024 by Rejaul Karim

In the financial landscape, the paper “The Many Colours of CAPE” by Farouk Jivraj and Robert J. Shiller intricately explores the complexities of the Cyclically-Adjusted Price to Earnings ratio (CAPE).

Published in the Yale ICF Working Paper No. 2018-22 on October 13, 2017, the study delves into the ongoing debate around CAPE’s predictive power, especially with the current CAPE standing at 31.21 for US stock markets. Through meticulous analyses, the authors find that, among its peers, CAPE consistently displays both economic and statistical significance.

They explore alternative constructions of CAPE, emphasizing its resilience in various scenarios, and showcase practical applications in asset allocation and relative valuation. This intellectual journey illuminates CAPE’s significance, providing nuanced insights into its role in financial valuations.

Abstract Of Paper

Campbell & Shiller’s [1988] Cyclically-Adjusted Price to Earnings ratio (CAPE) has both its advocates and critics. Currently, the debate is on the validity of the high CAPE ratio for US stock markets in forecasting lower future returns, with CAPE currently at 31.21. We investigate the efficacy and validity of CAPE from several different perspectives. First, we run multiple-horizon predictability regressions for CAPE versus its peers and find that CAPE consistently displays economic and statistical significance far better than any of its peers. Second, we explore alternative constructions of CAPE based on other proxies for earnings motivated by the work of findings by Siegel [2016] using NIPA profits. We find that original CAPE is still best when comprehensively and fairly reviewing the other proxies, even for NIPA profits. Third, we assess how to practically use CAPE in both an asset allocation and relative valuation setting. We demonstrate a novel use of CAPE for asset allocation programmes as well as discuss relative valuation exercises for country, sector and single stock rotation.

Original paper – Download PDF

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Author

Farouk Jivraj
Fidelity Investments, Inc. – Fidelity Management & Research; Imperial College Business School

Robert J. Shiller
Yale University – Cowles Foundation; National Bureau of Economic Research (NBER); Yale University – International Center for Finance

Conclusion

In conclusion, the discourse surrounding Campbell and Shiller’s Cyclically-Adjusted Price to Earnings ratio (CAPE) is a nuanced exploration of its efficacy and validity. The present scrutiny, particularly regarding the high CAPE ratio for US stock markets, unfolds through various lenses.

Empirical evidence reveals CAPE’s consistent economic and statistical significance across multiple-horizon predictability regressions, outperforming its peers. Exploration of alternative CAPE constructions based on various earnings proxies underscores the resilience of the original CAPE, even when compared comprehensively.

Beyond its forecasting role, the study introduces innovative applications of CAPE, demonstrating its practical utility in asset allocation programs and relative valuation exercises. This comprehensive analysis not only reaffirms CAPE’s robustness but also enriches its relevance in diverse financial contexts, emphasizing its multifaceted role beyond mere forecasting.

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FAQ

1. What is the primary focus of the paper “The Many Colours of CAPE” by Farouk Jivraj and Robert J. Shiller?

The paper delves into an in-depth exploration of the Cyclically-Adjusted Price to Earnings ratio (CAPE), originally introduced by Campbell and Shiller in 1988. The authors specifically investigate the ongoing debate surrounding CAPE’s predictive power, especially in light of its current standing at 31.21 for US stock markets.

2. How does CAPE compare to its peers in terms of predictability, and what alternative constructions are explored in the paper?

The paper conducts multiple-horizon predictability regressions for CAPE against its peers, finding that CAPE consistently demonstrates both economic and statistical significance, surpassing its counterparts. Additionally, the authors explore alternative constructions of CAPE based on other proxies for earnings, including NIPA profits, and conclude that the original CAPE remains superior, even when comprehensively reviewing other proxies.

3. What practical applications and insights does the paper provide regarding CAPE’s role in financial valuations?

The authors showcase practical applications of CAPE in asset allocation programs and relative valuation exercises. They introduce a novel use of CAPE for asset allocation and discuss its application in relative valuation exercises for countries, sectors, and individual stocks. This highlights the paper’s emphasis on the multifaceted role of CAPE beyond forecasting, enriching its relevance in diverse financial contexts.

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