Improving How We Estimate Future Stock Market Returns

Behind the scenes, widely used valuation tools help shape expectations about whether markets are expensive, cheap or somewhere in between. One of the most influential measures is the Cyclically Adjusted Price-Earnings (CAPE) ratio, a long-term indicator often cited by investors, economists and commentators when discussing market conditions.

New research from Massey Business School academics Professor Ben Marshall and Professor Nuttawat Visaltanachoti is helping refine how that judgement is made by improving a trusted tool.

The CAPE ratio compares the current value of the United States share market with companies’ average earnings over the past decade. A higher ratio suggests markets may be expensive, while a lower ratio points to cheaper valuations.

Professor Visaltanachoti says the measure has endured in part because of its simplicity and pedigree.

“The CAPE ratio compares the current value of the S&P 500, which tracks the performance of 500 of the largest listed companies in the United States, to average annual earnings over the last ten years. It was proposed by Robert Shiller, who later won a Nobel Prize and has become one of the most closely watched valuation measures in global markets.”

Professor Marshall says they discovered two main issues with the CAPE ratio.

“First, the traditional CAPE ratio includes earnings from companies that are no longer part of the index being analysed. Second, it weights companies by earnings rather than by size.”

Share market indices, including the S&P 500, are weighted by company size, meaning the largest firms have the greatest influence on overall market movements. This new research adjusts the CAPE ratio to reflect this structure more accurately.

Rather than overhauling the measure entirely, Professor’s Visaltanachoti and Marshall focused on making a targeted improvement, aligning the valuation tool with the reality of markets. The adjusted approach provides a more accurate forecast of future ten-year returns for the S&P 500.

However, Professor Marshall says stock returns remain very difficult to forecast.

“We don’t want to create the impression that the traditional approach is terrible and our approach is fantastic. This is about an important incremental advance.

“That incremental advance matters because valuation tools influence long-term behaviour, even indirectly. They shape how investors assess risk, how retirement funds allocate capital and how policymakers and commentators interpret market conditions. More accurate forecasts, lead to better investment decision-making,” Professor Marshall adds.

The research has attracted international attention, including coverage by the Financial Times, highlighting its relevance beyond academic circles.

Professor Marshall says the recognition confirms the rigour and real-world relevance of the work.

“Ultimately, we hope our work helps improve understanding of one of the most commonly referenced tools in financial markets, giving readers a clearer sense of how markets are assessed and why those assessments matter over the long term.”

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