CAPE has long been a cornerstone of long-term return forecasting. High valuations mean lower future returns. Low valuations mean higher future returns. Critics argue that its predictive power has waned in recent decades. This letter pushes back. It shows that the apparent decline is largely a measurement problem. When CAPE is constructed using proxied index components and market capitalization weights, its out-of-sample predictive power exceeds 50 percent for ten-year returns. The result is a more accurate and economical way to use assessment over the long term asset allocation.
CAPE Ratios and Long-Term Returns
- Ma, Marshall, Nguyen, and Visaltanachoti
- Working paper, 2026
- A version of this paper can be found here here
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Key academic insights
The traditional CAPE mixes different components of the index over time
The CAPE standard divides today’s index level by ten-year average earnings. However, firms move in and out of the S&P 500 over time. The counter reflects the actual ingredients. The denominator includes earnings from firms that may no longer be in the index. The authors construct a Component CAPE that approximates prices and profits for the same firms. This simple correction materially improves predictive accuracy.
Out-of-sample predictive power exceeds 50 percent
Using an out-of-sample constant-slope framework, the component’s 10-year earnings CAPE achieves an OOS R² of 0.5752, compared to 0.4667 for the overall CAPE. The improvement is statistically significant and robust to bootstrap inference, Bonferroni correction, and false discovery rate adjustments.
The improvement is strongest in recent decades
Predictive earnings are not limited to early sample periods. In fact, performance is stronger in the later subperiod when many commentators argued that CAPE had stopped working. The valuation-return relationship appears stable after measurement is corrected.
Weight drives a lot of the difference
Mathematically, the traditional Aggregate CAPE is close to the earnings-weighted average of firm-level CAPEs. The CAPE component instead uses market capitalization weights. This weighting difference explains a significant portion of the variation in levels and predictive power. The market cap-weighted construction better reflects how capital is actually distributed in the index.
Economic value survives implementation tests
When used in a dynamic asset allocation framework, Component CAPE yields returns equivalent to certainty higher than the historical average benchmark and a static 60/40 allocation. Gains are moderate but consistent across all specifications.
Practical applications for investment advisors
Align your rating data
If you rely on CAPE for strategic allocation, use a version that matches current constituents to their historical earnings. Avoid mixing different sets of firms between the numerator and the denominator.
Consider the weight
Realize that traditional CAPE implicitly resembles an earnings-weighted measure. A market capitalization weighted construction produces systematically different signals. Choose the weighting scheme purposefully.
Focus on long horizons
The predictive power documented here applies to ten-year returns. CAPE is not a tactical time tool. It is an input of strategic allocation.
Combine with complementary signals
Assessment works best as a pillar in a wider framework. Integrate it with trend, macro or risk-based signals rather than relying on a single metric.
How to explain this to customers
“Valuations are still important. The apparent decline in CAPE’s utility largely reflects how it was measured. By aligning the index components and using appropriate weights, we recover strong long-term predictive power. CAPE is not a short-term timing tool. It is a disciplined way to set long-term expectations and guide strategic asset allocation.”
The most important chart from the paper
Results are hypothetical results and are NOT an indication of future results and do NOT represent returns actually achieved by any investor. Indices are not managed and do not reflect management or trading fees, and one cannot invest directly in an index.
ABSTRACT
We demonstrate that 10-year stock market returns are significantly more predictable with respect to price-earnings ratios than previously thought. The traditional approach involves relating the current index price level, based on current index components, to prior years’ index earnings, calculated using those years’ components. When we estimate the cyclically adjusted price-earnings ratio (CAPE), ensuring that the prices and earnings of the index components are in line and applying a superior regression approach, the out-of-sample R2 values are above 50%. The Component CAPE ratio weights the individual CAPE ratios of stocks by their market capitalization, while the traditional CAPE ratio is closer to weighting earnings.
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Important discoveries
For informational and educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Some information is considered reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become out of date or be replaced without notice. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.
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