Predicting the market PE

There is a simple model used to estimate the “intrinsic PE” of the market (examples at the San Fran Fed) based on macro market variables.

You can take CBO (congressional budget office) potential output growth forecasts, and strike a predicted R* (natural, or equilibrium, rate of interest) based on a 3rd order polynomial using LM or LW rates.

We will be using these forecast measures to make our predictions (well, better called estimates).


The predicted R* will look something like this, rising and falling (as theory predicts) with the path of output growth. You can see the fitted values are okay, but hardly perfect, and it matters which one you use, as they have some marked level and continuity differences.


Now the level of R* matters, and is negatively correlated to the level of the PE ratio, but the rate of change in R* is positively associated, as increases in R* are occurring because of improved economic growth expectations, which are generally supportive of profits and higher multiples.

Again, not perfect, but we can see the general idea about changes in the PE, and changes in the natural rate (note the date in the below graph cuts off prior to the pandemic).


Inflation enters the equation, despite both measures (PE, natural rates) being in real terms. And that’s quite problematic for our little “predicted PE” measure. Inflation has a negative loading, and the recent very large spike in inflation does tank the predicted measure somewhat.

Still, what we are meant to notice, is that the predicted and the actual PE values differ quite markedly, with the model noting a similar level of “overvalued”-ness as the tech era.


We don’t think it is quite that bad, in aggregate, and note also that the longer run measure bounces back as R* rises over the forward horizon, and inflation (hidden in my model) reverts to 2% over a year or two. That means the “25x CAPE” ratio is probably the one to look at, rather than the 21x CAPE ratio.

This sort of model is hardly conclusive, but I suppose if you were max 20% OW equities, it could factor into one’s thinking. It factors into ours, and we are in fact moderately underweight equities, at the DAA level, with a 3% UW to international equities, and a 3% UW to Australian shares.

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