Why the High Values for the CAPE Ratio in Recent Years Might Be Justified

Abstract

In this paper, I propose a tracking error approach using the P/E ratio equation to approximate the CAPE Ratio. After accounting for the recent structural changes in the composition and valuation of the S&P 500 index, along with a persistently low interest rate environment over the last three decades, I show that the average CAPE Ratio had increases over time. Relying solely on historical CAPE averages to forecast equity returns may therefore prove unreliable. The findings in this paper indicate that investors should incorporate multiple factors, including required return and expected earnings growth, when forming capital allocation decisions across asset classes. Rotating out of the equity market simply because the CAPE Ratio shows that the equity market is too expensive might not produce the desire outcome investors hope for.