As noted in an earlier post, CAPE is a uniquely reliable predictor of future stock prices. It tends to correctly forecast the long-term direction, up or down, although it does better for the distant future than for next month or even the next year or two. A refined version of CAPE, called LogrCAPE0.33%, is shown below for the years from 1896 through 2015.*
It's reasonable to ask whether CAPE would be a better predictor if its long trend were taken into consideration. Accordingly, the next chart adjusts the LogrCAPE0.33% metric by removing the trend.** The picture is more balanced, with values above and below zero occurring in every quarter-century. And the new trend-line is flat (a statistical necessity). Looking at recent values, the selloff in 2008 and early 2009 now looks like a good buying opportunity, with the de-trended CAPE hitting a low of -0.5. The current, near-normal value raises no alarm to avoid stocks.
A rational person could take either side of the argument. Our calculators strike a compromise. They report value-adjusted allocations to stocks and bonds by first averaging LogrCAPE0.33% and the de-trended CAPE, then estimating allocations and returns from that average. Additional details about the statistical machinery of the calculators are posted here.
** The trend-line is a log-linear cubic polynomial. The de-trended CAPE is simply LogrCAPE0.33% minus the value predicted by the least square fit of the cubic model.
*** The to-be-predicted variable in the analysis was the actual, inflation-adjusted, compound annual return of U.S. stocks, with dividends reinvested. The returns were computed for all holding periods from one to 20 years, plus all even-numbered holding periods from 22 to 40 years, from January 1896 through December 2015. In a least-squares regression, the observed returns were predicted from a combination of CAPE and the holding period, using a function of the form r = b * c * POWER( m, y ) + a, where r is the log-real-return; c is the de-trended CAPE or LogrCAPE0.33%; a, b, and m are fitted constants; and y is the holding period.