The CAPE Ratio (Shiller PE): How to Predict 10-Year Returns with 90% Accuracy
The CAPE Ratio (Shiller PE): How to Predict 10-Year Returns with 90% Accuracy
๐ WHO THIS IS FOR
- Target Profile: Long-term investors allocating new capital or rebalancing large portfolios ($1M+).
- Primary Objective: Strategic Allocation (Avoiding “buying the top” of a bubble).
- Not Suitable For: Short-term traders or those who believe “this time is different” (New Paradigm theorists).
EXECUTIVE SUMMARY
- The Metric: Standard P/E ratios are volatile because earnings fluctuate wildly in recessions. The Cyclically Adjusted Price-to-Earnings (CAPE) ratio uses the 10-year average of inflation-adjusted earnings to smooth out the noise.
- The Signal: CAPE is a terrible short-term timer (it stayed “expensive” from 1996 to 2000), but an excellent long-term predictor. A high CAPE (>30) historically guarantees low returns over the next decade. A low CAPE (<15) signals massive future returns.
- The Strategy: Instead of “All In” or “All Out,” use CAPE for Dynamic Allocation. When CAPE is high, tilt toward cheaper sectors (Value/International). When CAPE is low, go heavy on the S&P 500.
- Authority Baseline: Nobel Laureate Robert Shiller’s research proves that valuation determines long-term returns. Starting valuation explains ~90% of 10-year future returns.
“Buy and Hold” is good advice. “Buy Cheap and Hold” is better advice. The CAPE Ratio is the thermometer of the market. It tells you if the patient is running a fever (Bubble) or hypothermia (Crash). According to Team BMT Analysis, ignoring CAPE today (currently >30) is betting that trees will grow to the sky. History suggests they won’t. Source: Yale University / Robert Shiller Data
Scenario: US Tech Stocks (CAPE 35) vs. European Value Stocks (CAPE 14).
- The Dumb Money: Buys US Tech because “it went up last year.”
Risk: Buying at the top. Low expected return. - The CAPE Strategy (Barclays ETN): Systematically sells the most expensive sectors and buys the cheapest ones.
Action: Underweight US Tech, Overweight Europe/Energy.
Logic: Valuation mean reversion creates a tailwind for the cheap assets and a headwind for the expensive ones.
BMT Verdict: High valuations do not mean a crash is imminent. They mean the “Spring is stretched.” It can stay stretched for years (1996-2000). But eventually, it snaps back. If your retirement depends on the S&P 500 compounding at 10% from today’s levels, the CAPE ratio says you are likely to be disappointed. Adjust your plan, not the market.
Forecasting Power (Historical Data)
| Starting CAPE Ratio | Avg Annual Return (Next 10 Years) |
|---|---|
| Cheap (<10) | 16.0 |
| Fair (15-20) | 7.0 |
| Expensive (>25) | 3.0 |
*Chart Note: The correlation is undeniable. Buying at a CAPE of 30+ (like 1929, 2000, 2021) often leads to a “Lost Decade” of flat or negative real returns. Buying at a CAPE of 7 (1982) creates dynastic wealth.
The “New Normal” Debate: Critics argue that accounting changes (intangible assets, buybacks) make CAPE naturally higher today. Even Shiller acknowledges this, suggesting a “Modified CAPE” or “Excess CAPE Yield” (Stock yield minus Bond yield). However, even adjusted metrics flash “Caution” when the risk-free rate is 5% and equity yield is 4%.
โ BOUNDARY CLAUSE: This Structure Breaks Down If:
- You Use It for Market Timing: If you sell everything because CAPE hits 25, you might sit in cash while the market runs to CAPE 45 (like the Dot-Com bubble). CAPE is a compass, not a GPS. Use it to tilt, not to exit.
- Structural Shifts: If corporate tax rates drop permanently or margins expand permanently due to AI, historical CAPE averages may be too low. (Though “this time is different” is usually the most expensive sentence in finance).
Execution Protocol
Visit authoritative sources (Shiller’s Yale website or Multpl.com) to see the current S&P 500 CAPE. Compare it to the 20-year average.
If US CAPE is 32 and Emerging Markets CAPE is 12, the expected return gap is massive. Shift allocations. Action: Reduce SPY (S&P 500), Increase VEA (Developed Markets) or VWO (Emerging Markets).
CAPE (DoubleLine Shiller Enhanced CAPE): A fund that uses the sector rotation strategy. It buys the 4 cheapest sectors (Value) and avoids the expensive ones. OSS (Ossiam Shiller Barclays CAPE US Sector): Another implementation of the sector value strategy.
Valuation is gravity. It can be defied for a while, but never forever. Using CAPE allows you to align your portfolio with the forces of physics rather than the whims of sentiment.
WEALTH STRATEGY DIRECTIVE
- Do This: Use high CAPE environments to harvest gains and pay down debt or buy real assets. Cash is an option when expected equity returns are 3%.
- Avoid This: Comparing today’s P/E (1-year earnings) to history. Earnings today might be at a cyclical peak. Always use the 10-year average (CAPE) to normalize the business cycle.
Frequently Asked Questions
Is CAPE predictive for 1 year?
No. The R-squared (predictive power) for 1 year is nearly zero. The market can remain irrational longer than you can remain solvent. It is only predictive for 10-year periods.
What is a “Fair” CAPE?
Historically ~16-17. In the modern era (post-1990), maybe ~20-22 due to lower interest rates and better tech margins. Anything above 30 is historically in the “Bubble Zone.”
Does it work for individual stocks?
Yes, but less reliably. A single company can change its business model (e.g., Amazon moving from retail to cloud), making 10-year-old earnings irrelevant. It works best on Indices and Sectors.