Capitol Report: Elevated CAPE ratio suggests stock market returns to decline, regional Fed bank finds

What goes up…

A popular measure of valuing stocks looks set for a decline, and stock returns will suffer because of it, according to new research published Monday by the Federal Reserve Bank of San Francisco.

The cyclically-adjusted price-to-earnings, or CAPE, ratio is the inflation-adjusted value of the S&P 500 index SPX, +0.16%  divided by the real earnings of companies in the index averaged over the most recent 10 years.

Going back to 1881, big run-ups in the CAPE ratio—usually from the advent of new technologies including high-speed rail, automobiles and the internet—were met with substantial decline in stock prices.

The quarterly average CAPE ratio stands at around 30, exceeded only by the peak values of 43 in 2000 and 31 in 1929, according to a paper from San Francisco Fed research adviser Kevin Lansing.

Lansing compared the CAPE ratio against different economic variables to determine whether it’s signaling that stocks are overvalued. So far, the answer isn’t really—the actual CAPE ratio is about 8% above where a regression model that includes the natural rate of interest, potential GDP and core inflation suggests it should be. It was 40% above the fitted ratio in early 2000, at the peak of the internet bubble.

But the projected path of that model implies a 13% decline in the CAPE ratio over the next 10 years.

“All else being equal, stock returns in this case would be lower than those observed since 2009 when the CAPE ratio was doubling. Investors who expect high stock returns in the coming years based on recent market experience may end up being disappointed,” he wrote.

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