Excess CAPE Yield (ECY) and Subsequent 10 Year Annualized Excess Returns

May 17, 2021 - Valuation, Stocks

FAQ

1. What is this chart saying?

The chart says that the stock market's valuation has some impact on returns over many years, in this case, 10 years. Valuation may not matter much at all over a day, week, month, or year. However, over many years there is a mean reversion tendency with the market's valuation that provides some impact on returns. This impact is most notable at the extremes when valuation is extremely cheap and extremely expensive, so the impact of valuation starts to dominate the other forces that govern stock market returns.

2. What isn't valuation perfect?

There is a reason why markets get expensive or cheap in the first place. These causes, while ultimately temporary in the grand scheme of things, can come and go in a way that isn't guaranteed. So valuation gives some edge. Understanding these other trends is needed to improve our understanding of future returns.

3. What is CAPE?

CAPE is the average inflation-adjusted earnings for the past 10 years divided by the inflation-adjusted stock price. This manipulation helps to remove cyclical fluctuations in earnings, which can fall dramatically during recessions.

CAPE was developed by Robert Shiller. You can get more information at Robert Shiller's website.

4. What is the Excess CAPE Yield?

Converting CAPE to a yield allows you to compare it to bond yields. Since stocks are riskier than bonds, we would expect the yield on stocks to be greater than the yield on bonds. If the spread is very high, then stocks may be cheap. If the spread is very narrow, then stocks may be expensive.