Uncloaking Campbell and Shiller’s CAPE: A Comprehensive Guide to Its Construction and Use

Campbell and Shiller’s cyclically adjusted P/E (CAPE) has proven to be a powerful descriptor, and useful predictor, of long-term equity returns in the United States and some global markets. In recent years, though, it has been criticized for being overly pessimistic about the prospects for equity returns, lacking robustness to distortions in corporate earnings and overstating the predictability of returns at long horizons because of overlapping observations and endogeneity, particularly when estimated using ordinary least squares (OLS). This article explores various definitions of CAPE and presents new construction techniques that make it robust to a wide range of accounting and index construction biases, as well as to changing equity market fundamentals. The authors evaluate CAPE’s forecasts over various time periods using econometric methods that account for endogeneity, overlapping observations, and the presence of outliers. Many of these enhancements have minimal impact on CAPE and its U.S. equity market forecasts, but they prove to be useful in smaller markets and in markets that experienced significant dislocations. The authors also show that using accounting-flow variables such as cash flow and revenues in place of earnings and cyclically adjusted earnings can effectively supplement, and even enhance, CAPE’s market return forecasts. Finally, they show that CAPE and its variants forecast nominal returns more effectively than real returns and that the current 10-year forecast for the S&P 500 Index return is about 5.8% per annum.