No. 1393 - Economic fundamentals and stock market valuation: a CAPE-based approach

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by Maria Ludovica Drudi and Federico Calogero NuceraNovember 2022

The paper analyses, for different countries, the relationship between the Cyclically-Adjusted Price-to-Earnings (CAPE) ratio and some macroeconomic variables such as the interest rate, industrial production and uncertainty about economic growth and inflation. The estimates provide a value of the CAPE that is coherent with the fundamentals (fair value) and can be used to evaluate if stock markets are over- or undervalued and to improve stock market returns forecasts with respect to alternative models.

The main results are the following: 1) an increase in the real interest rate and in the uncertainty about growth and inflation are generally associated with a reduction in the CAPE. On the contrary, there is a positive relationship with the growth of industrial production; 2) for some countries and some time horizons, the deviations of the CAPE from its fair value improve the forecasting of equity returns compared with the alternative models usually proposed in the literature.

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