Shiller's CAPE: Market Efficiency and Risk

Robert Shiller shows that Cyclically Adjusted Price to Earnings Ratio (CAPE) is strongly associated with future long-term stock returns. This is often interpreted as evidence of market inefficiency. We present two findings contrary to such an interpretation. First, if markets are efficient, stock returns should be higher than the risk-free rate. We find that even when CAPE is in its ninth decile, future 10-year stock returns, on average, are higher than future returns on 10-year U.S. Treasurys. Thus, the results are largely consistent with market efficiency. Second, consistent with a risk-return tradeoff, we find that CAPE is negatively associated with future stock market volatility.