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Key Insights:

CAPE as a Valuation Tool

• The study develops and validates a fair-value model for stock market valuation using the Cyclically Adjusted Price-to-Earnings (CAPE) ratio.

• CAPE is positively correlated with economic growth and negatively correlated with real interest rates and economic volatility.

Macroeconomic Drivers of CAPE

• Interest Rates: Higher real interest rates lead to lower CAPE levels.

• Economic Growth: Faster-growing economies tend to have higher CAPE ratios.

• Economic Volatility: Increased uncertainty (e.g., fluctuations in industrial production and inflation) suppresses CAPE.

Market Overvaluation and Future Returns

• When CAPE deviates significantly from fair value, future stock returns tend to decline.

• Overvalued markets, as indicated by excessive CAPE levels, are more prone to corrections.

Superior Predictive Power of Fair-Value-Adjusted CAPE

• Models using CAPE deviations from fair value outperform those using absolute CAPE levels.

• Incorporating macroeconomic variables improves valuation accuracy and return predictions.

Policy Implications

• Monetary Policy: Price stability contributes to stock market stability.

• Fundamental-Based Investing: Long-term stock valuations should account for macroeconomic fundamentals.

Conclusions:

• CAPE is an effective tool for assessing stock market overheating.

• Adjusted CAPE models incorporating macroeconomic factors enhance market predictions.

• Interest rates, growth, and volatility are critical for understanding valuation trends.

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