{"id":240746,"date":"2026-03-26T13:30:36","date_gmt":"2026-03-26T17:30:36","guid":{"rendered":"https:\/\/ibkrcampus.com\/campus\/?p=240746"},"modified":"2026-03-30T13:14:02","modified_gmt":"2026-03-30T17:14:02","slug":"increases-cape-ratio-predictability-with-a-simple-adjustment","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/ibkr-quant-news\/increases-cape-ratio-predictability-with-a-simple-adjustment\/","title":{"rendered":"Increases CAPE Ratio Predictability with a Simple Adjustment"},"content":{"rendered":"\n<p><em>The article &#8220;Increases CAPE Ratio Predictability with a Simple Adjustment&#8221; was originally posted on <a href=\"https:\/\/alphaarchitect.com\/cape-ratios\/\">Alpha Architect<\/a> blog.<\/em><\/p>\n\n\n\n<p>CAPE has long been a cornerstone of long-horizon return forecasting. High valuations imply lower future returns. Low valuations imply higher future returns. Critics argue that its predictive power has faded in recent decades. This paper pushes back. It shows that the apparent decline is largely a measurement problem. When CAPE is constructed using aligned index constituents and market-cap weights, its out-of-sample predictive power exceeds 50 percent for ten-year returns. The result is a more precise and economically meaningful way to use valuation for long-term&nbsp;<a href=\"https:\/\/alphaarchitect.com\/relative-sentiment-and-machine-learning-for-tactical-asset-allocation-out-of-sample-results\/\" target=\"_blank\" rel=\"noreferrer noopener\">asset allocation<\/a>.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-cape-ratios-and-long-term-returns\"><strong>CAPE ratios and Long Term Returns<\/strong><\/h2>\n\n\n\n<ul class=\"wp-block-list\">\n<li>Ma, Marshall, Nguyen and Visaltanachoti<\/li>\n\n\n\n<li>Working paper, 2026<\/li>\n\n\n\n<li>A version of this paper can be found\u00a0<a href=\"https:\/\/papers.ssrn.com\/sol3\/papers.cfm?abstract_id=6060895\" target=\"_blank\" rel=\"noreferrer noopener\">here<\/a><\/li>\n\n\n\n<li>Want to read our summaries of academic finance papers? Check out our\u00a0<a href=\"https:\/\/alphaarchitect.com\/category\/architect-academic-insights\/academic-research-insight\/\" target=\"_blank\" rel=\"noreferrer noopener\">Academic Research Insight<\/a>\u00a0category<\/li>\n<\/ul>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-key-academic-insights\">Key Academic Insights<\/h2>\n\n\n\n<p><strong>The traditional CAPE mixes different index constituents across time<\/strong><br>The standard CAPE divides today\u2019s index level by ten-year average earnings. However, firms enter and exit the S&amp;P 500 over time. The numerator reflects current constituents. The denominator includes earnings from firms that may no longer be in the index. The authors construct a Component CAPE that aligns prices and earnings for the same firms. This simple correction materially improves predictive accuracy.<\/p>\n\n\n\n<p><strong>Out-of-sample predictive power exceeds 50 percent<\/strong><br>Using a constant-slope out-of-sample framework, the Component 10-Year Earnings CAPE achieves an OOS R\u00b2 of 0.5752, compared to 0.4667 for the Aggregate CAPE. The improvement is statistically significant and robust to bootstrap inference, Bonferroni correction, and false discovery rate adjustments.<\/p>\n\n\n\n<p><strong>The improvement is stronger in recent decades<\/strong><br>The predictive gains are not confined 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 once measurement is corrected.<\/p>\n\n\n\n<p><strong>Weighting drives much of the difference<\/strong><br>Mathematically, the traditional Aggregate CAPE is close to an earnings-weighted average of firm-level CAPEs. The Component CAPE instead uses market-cap weights. This weighting change explains a substantial portion of the difference in levels and predictive power. The market-cap weighted construction better reflects how capital is actually allocated in the index.<\/p>\n\n\n\n<p><strong>Economic value survives implementation tests<\/strong><br>When used in a dynamic asset allocation framework, the Component CAPE delivers higher certainty equivalent returns than both the historical mean benchmark and a static 60\/40 allocation. The gains are moderate but consistent across specifications.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-practical-applications-for-investment-advisors\">Practical Applications for Investment Advisors<\/h2>\n\n\n\n<p><strong>Align your valuation inputs<\/strong><br>If you rely on CAPE for strategic allocation, use a version that aligns current constituents with their own historical earnings. Avoid mixing different firm sets across numerator and denominator.<\/p>\n\n\n\n<p><strong>Be mindful of weighting<\/strong><br>Recognize that the traditional CAPE implicitly resembles an earnings-weighted measure. A market-cap weighted construction produces systematically different signals. Choose the weighting scheme deliberately.<\/p>\n\n\n\n<p><strong>Focus on long horizons<\/strong><br>The predictive power documented here applies to ten-year returns. CAPE is not a tactical timing tool. It is a strategic allocation input.<\/p>\n\n\n\n<p><strong>Combine with complementary signals<\/strong><br>Valuation works best as one pillar in a broader framework. Integrate it with trend, macro, or risk-based signals rather than relying on a single metric.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-how-to-explain-this-to-clients\">How to Explain This to Clients<\/h2>\n\n\n\n<p>\u201cValuations still matter. The apparent decline in CAPE\u2019s usefulness largely reflects how it was measured. By aligning index constituents 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-horizon expectations and guide strategic asset allocation.\u201d<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-the-most-important-chart-from-the-paper\">The Most Important Chart from the Paper<\/h2>\n\n\n\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"808\" height=\"672\" data-src=\"https:\/\/www.interactivebrokers.com\/campus\/wp-content\/uploads\/sites\/2\/2026\/03\/cape-alpha-archictect.png\" alt=\"CAPE ratio\" class=\"wp-image-240754 lazyload\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2026\/03\/cape-alpha-archictect.png 808w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2026\/03\/cape-alpha-archictect-700x582.png 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2026\/03\/cape-alpha-archictect-300x250.png 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2026\/03\/cape-alpha-archictect-768x639.png 768w\" data-sizes=\"(max-width: 808px) 100vw, 808px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 808px; aspect-ratio: 808\/672;\" \/><\/figure>\n\n\n\n<p><\/p>\n\n\n\n<p id=\"h-the-results-are-hypothetical-results-and-are-not-an-indicator-of-future-results-and-do-not-represent-returns-that-any-investor-actually-attained-indexes-are-unmanaged-and-do-not-reflect-management-or-trading-fees-and-one-cannot-invest-directly-in-an-index\"><em>The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.\u00a0Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index<\/em>.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-abstract\">Abstract<\/h2>\n\n\n\n<p>We demonstrate that 10-year equity market returns are considerably more predictable in relation to price\u2013earnings ratios than previously thought. The traditional approach involves relating the current index price level, based on current index components, to the index earnings of previous years, calculated using those years\u2019 components. When we estimate the cyclically adjusted price\u2013earnings (CAPE) ratio, ensuring that index component prices and earnings are aligned, and apply a superior regression approach, out-of-sample R2 values are over 50%. The Component CAPE ratio weights individual stock CAPE ratios by their market capitalization, whereas the traditional CAPE ratio is more closely aligned with earnings weighting.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>CAPE has long been a cornerstone of long-horizon return forecasting.<\/p>\n","protected":false},"author":152,"featured_media":54254,"comment_status":"open","ping_status":"closed","sticky":true,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":"","jetpack_post_was_ever_published":false},"categories":[339,338,341],"tags":[4049,1006,19245],"contributors-categories":[13651],"class_list":{"0":"post-240746","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-data-science","8":"category-ibkr-quant-news","9":"category-quant-development","10":"tag-cape-ratio","11":"tag-fintech","12":"tag-strategic-asset-allocation","13":"contributors-categories-alpha-architect"},"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v26.9 (Yoast SEO v27.8) - https:\/\/yoast.com\/product\/yoast-seo-premium-wordpress\/ -->\n<title>Increases CAPE Ratio 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