CAPE and the Great Moderation

The widespread and pronounced decline in the volatility of the US economy beginning in the latter half of the 20th century known as the “great moderation” was accompanied by an increase in both the stability and the levels of stock-market valuations. This concurrence likely was not due to luck, the author contends. Moderation of economic indicators conceivably induced greater risk-taking, pushing up valuation measures like CAPE while at the same time reducing its variance. The author performs statistical tests to show that the time series process underlying CAPE’s volatility and trend changed not long after the great moderation began, and suggests a mechanism linking these events to CAPE’s climb. Finally, the author speculates that a reversal of the conditions that fostered the great moderation may have adverse consequences for stock-market valuations.