Excess CAPE Yield Low Ahead of Potential Interest Rate Cut

With the probability of an interest rate cut occurring next week, I decided to revisit a stock market valuation measure that adjusts for interest rates: The excess CAPE yield (ECY). This ratio currently suggests the S&P 500 index’s valuation is in the top third of all historical readings.

The excess CAPE yield has its basis in Nobel laureate Robert Shiller’s cyclically adjusted price-earnings (CAPE) ratio. The CAPE ratio uses 10 years’ worth of earnings instead of one year like traditional price-earnings (P/E) ratios use. It is intended to predict stock market returns over the next five to 10 years. (The CAPE ratio is currently at 35.2, which is very high.)

The excess CAPE yield inverts the current CAPE ratio (1 ÷ CAPE) and then subtracts the real (inflation-adjusted) 10-year interest rate from it. Inversing the CAPE ratio creates a long-term, inflation-adjusted earnings yield. It is akin to the traditional earnings yield (earnings for the last four quarters divided by price, or E/P) that is used to compare stocks to bonds.

As of the start of September, the excess CAPE yield is 1.83%. This is down from its coronavirus pandemic peak of 4.88% in 2020. It is also below the long-term average of 4.63% and the long-term median of 3.36%. Lower numbers signal higher valuations since yield and valuation are inversely related.

You can observe this in the table. I grouped the individual monthly excess CAPE yields by percentile ranges. As the excess CAPE yield has increased, so have the average real (inflation-adjusted) 10-year returns realized by the S&P 500. (Each 10-year period follows the individual month an excess CAPE yield was calculated for.) Since Shiller had it in his data, I also listed the average real returns for 10-year Treasury bonds.

The historical data suggests—but in no way guarantees—lower real returns for the S&P 500 going forward. The average 10-year return for the S&P 500 when the excess CAPE yield has ranged between 1% and 2% is 4.21%. For context, the average 10-year return over all periods in Shiller’s data is 6.67%.

If inflation stays near its long-term average of 3% (and, yes, that is a big “if”), the numbers translate to an annualized 10-year absolute return of about 7%.

Below-average returns for the S&P 500 do not necessarily mean below-average returns for other types of stocks. As I have been pointing out, the large-cap S&P 500 is currently unusually top heavy. The 10 largest stocks accounted for 35.5% of the S&P 500’s total market capitalization at the end of August. Those same stocks are also driving up the index’s overall price-earnings ratio.

Value stocks—especially small-cap value stocks—remain historically cheap relative to the S&P 500. Foreign indexes have been experiencing an unusually long streak of underperforming the S&P 500. A swing of the pendulum could result in one or both stock categories outperforming the S&P 500 going forward. We can’t say with certainty what will happen, but we do know that diversification increases your odds of being in the right type of investment at the right time.