Forecasting US Equity Market Returns with Machine Learning

Shiller's CAPE ratio is a popular and useful metric for measuring whether stock prices are overvalued or undervalued relative to earnings. Recently, Vanguard analysts Haifeng Wang, Harshdeep Singh Ahluwalia, Roger A. Aliaga-Díaz, and Joseph H. Davis have written a very interesting paper on forecasting equity returns using Shiller's CAPE and machine learning: "The Best of Both Worlds: Forecasting US Equity Market Returns using a Hybrid Machine Learning – Time Series Approach". First, what is the Shiller CAPE ratio? 1 If we do a simple regression of Shiller's CAPE ratio against future 10-year returns, we observe a very strong relationship. Here we see a historical chart of actual 10-year annualized stock returns vs. those predicted by Shiller's CAPE. Using the Shiller regression, the current CAPE of about 30 suggests near-zero real return over the next 10 years.