Analyzing Changing “Investor Exuberance”: The Determinants of S&P Composite Index Total Return CAPE Changes.

We analyze the determinants of changes in S&P Composite Index Total Return Cyclically Adjusted Price-to-Earnings ratio (TR CAPE), to better understand changing “investor exuberance”. We use three different methods - linear regression using PCA, Lasso, and Ridge regression techniques – and a large number of explanatory variables, to compare and contrast the significant determinants. Different methods yield different results. Across all methods, we find that monthly changes in Michigan sentiment index is significantly associated with monthly changes in TR CAPE. When we cross check the results using annual changes (rather than monthly changes), across all methods, annual changes in Michigan sentiment index and changes in core inflation are significantly associated with annual changes in TR CAPE. Overall, changes in the Michigan Sentiment Index appears to have significant association with changes in investor exuberance. Michigan Sentiment Index is a measure of consumer sentiment, when high, typically reflects optimism about future economic growth, leading to increased consumer spending and higher corporate earnings expectations. This positive outlook can boost investor confidence, driving up stock prices and, consequently, increasing the TR CAPE ratio as markets anticipate stronger future earnings. In contrast, the financial crisis of 2008, for example, led to a sharp decline in the Michigan Sentiment Index as consumer confidence plummeted due to fears of a prolonged recession.