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Economic fundamentals and stock market valuation: a CAPE-based approach

Maria Ludovica Drudi () and Federico Calogero Nucera ()
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Maria Ludovica Drudi: Bank of Italy
Federico Calogero Nucera: Bank of Italy

No 1393, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: This paper estimates a fair-value model, based on macroeconomic fundamentals, of the Shiller Cyclically Adjusted Price-to-Earnings (CAPE) ratio. By performing a multi-country analysis, we find that CAPE – a widely used metric for stock market valuations – is, in general, positively related to economic growth and negatively related to the real long-term interest rate and to measures of economic volatility computed using industrial production and inflation data. Empirical evidence arising from predictive regressions of real stock market returns indicates that deviations of CAPE from its estimated fair value are negatively related to future stock returns. A prediction model based on these deviations outperforms, in many cases, a model based on the CAPE levels both in sample and out of sample.

Keywords: stock market valuation; CAPE; macroeconomic fundamentals; macroeconomic volatility; return predictability (search for similar items in EconPapers)
JEL-codes: E44 G12 (search for similar items in EconPapers)
Date: 2022-11
New Economics Papers: this item is included in nep-fdg
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