Update (12/31/2022):
It seems that new users have trouble registering for the forum. The confirmation email never shows up. I’ve decided to phase out this forum and transition over to a new forum plugin. The new location is here:
https://earlyretirementnow.com/forum-3/
Policies – please read!
- Everyone can read posts, but to start a new topic or add a reply you’d need to register. To create an ID, please verify your email address. You will get a link at that email address and you can then pick a password.
- Be courteous to others. Treat others like you like to be treated. Discuss the issues. No ad-hominem attacks!
- It’s OK to include external links if they are relevant. But please avoid spamming! Please no affiliate links.
- Before starting a new topic, please check if that question/topic has been discussed before already and add to that discussion instead of starting a new topic.
- If you’ve written a cool blog post that you want to share with others please post this in the “Self-Promo” category only!
- Please read the usual Disclaimers and the Privacy Policy!
- The forum policies may be amended in the future!
Is there a methodological reason to regress stock returns on Shiller's CAPE rather than CAPE's recriprocal, CAEY?
I used Shiller's monthly data (from http://www.econ.yale.edu/~shiller/data.htm) to regress 10-year annualized real total stock returns on each of CAPE and CAEY. The predicted returns are similar, EXCEPT for the almost-never-observed regime of CAPE>=30 / CAEY<=3.3% - see the attached picture.
In the CAPE>=30 / CAEY<=3.3% regime, regressing on CAPE predicts far more pessimistic returns than regressing on CAEY. I get the impression that CAPE is supposed to be used for this regression, but why? Obviously, since we are very much *in* the CAPE>=30 / CAEY<=3.3% regime, I would think that this question is actually very important!
I guess I would have thought that, if anything, it makes more sense to regress on CAEY, not CAPE, since CAEY *is* a kind of buy-and-hold stock return, given some assumptions such as that the past decade's average real earnings is an unbiased estimate of future earnings and that earnings can be monetized by the shareholder. And isn't more than a bit interesting that the return predicted by regressing on CAEY just *is* CAEY, more or less (see attached picture again)?
(Just to be clear, however, I don't mean to downplay how very expensive the market seems at the moment. Whether you use CAPE or CAEY, the market is in its historical top percentile by valuation. I'm NOT trying to promote a cavalier attitude about expected returns from stocks.)
I prefer the CAEY as the independent variable. If you do a scatter plot between x=CAPE y=return you will see that this is not a linear relationship. More of a y = a+b/x relationship. Not a good idea to regress this with a linear relationship and a negative slope.
@earlyretirementnowcom Shiller called a bubble in 1998 using a regression based on CAPE - I wonder how he would have defended using CAPE rather than CAEY?
@michigantuesday Can't say. He wasn't predicting SWRs. I find the translation of earnings yield into SWR or future returns far more intuitive.