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Are we paying tomorrow's returns today?

Are investors buying genuine growth, or paying today for returns that would normally arrive tomorrow? What the CAPE ratio says about Indian equity valuations and forward returns.

The Question

Markets rarely feel expensive while they are rising. Money is easy, the stories are good, and prices drift up quietly. So the question is: are investors buying real growth, or paying today for returns they would otherwise get tomorrow? If price says anything about the long run, expensive markets should lead to lower returns later. That is what the CAPE ratio tests.

What CAPE Measures

The Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, or Shiller's PE, divides the market's price by its average inflation-adjusted earnings over the past 10 years. A decade smooths out booms and recessions, which make any single year's earnings misleading. A high CAPE means paying more for each rupee of long-run earnings. A low one means equities are cheap against what they have historically earned.

Where India Stood

The last month with full 10-year returns after it is February 2016. In January 2016, a month before, CAPE was about 19.1, around the 28th percentile of its range: cheaper than much of the past, but not the deep discount of a crisis. Indian valuations move in clear cycles: cheap when money is tight and investors are nervous, expensive when money is easy and optimism drives big rallies.

Today's market sits in the most expensive fifth of its own history.

10-year cyclically adjusted P/E of the Nifty 500, monthly. The shaded bands are the cheapest and dearest fifths of the years over which forward returns can be measured, and the next 3 charts are built on them.

Nifty 500 ten-year CAPE monthly from April 2006 to January 2026, with the cheapest and most expensive fifths shaded; the January 2026 reading of 38.9 sits inside the most expensive fifth

CAPE, price to 10-year average real earnings

Cheapest fifth: below 18

Most expensive fifth: above 32.1

January 2026: 38.9, well inside the band that has delivered the weakest returns

Nifty 500 CAPE 10, monthly · Apr 2006 to Jan 2026

When Markets Get Pricey, What Comes Next?

History is split into five groups, from Q1 (the cheapest periods) to Q5 (the most expensive periods) by CAPE level.

The cheaper the market when you bought, the more it paid you after.

Every month from April 2006 to February 2016 sorted into 5 groups by starting CAPE, and the average annual return the Nifty 500 delivered over the 5 and 10 years that followed.

AVERAGE ANNUALISED TOTAL RETURN, PER CENT

Next 5 yearsNext 10 years

Q1 (CAPE 15 to 18)16.815.6
Q2 (CAPE 18 to 20)14.114.9
Q3 (CAPE 20 to 25)8.113.2
Q4 (CAPE 26 to 32)10.39.9
Q5 (CAPE 32 to 50)4.69.8
Average annualised five-year and ten-year total returns by starting CAPE quintile: 16.8 and 15.6 per cent from the cheapest fifth, falling to 4.6 and 9.8 per cent from the most expensive

From the dearest fifth, 5 years returned 4.6% a year. From the cheapest, 16.8%.

119 monthly starting points, roughly 24 per group. 10-year returns from the dearest fifth include the 2008 crash and the recovery after it, which is why the gap narrows over the longer horizon.

Nifty 500 CAPE 10 and Total Return Index · Apr 2006 to Feb 2016

The pattern is clear. Buying in the cheapest fifth (Q1) gave the strongest forward returns: about 16-17% a year over the next 5 years and about 15-16% over the next 10. Returns fall step by step as valuations rise. Buying in the most expensive fifth (Q5) gave about 4-5% over 5 years and about 10% over 10.

The 10-year gap between the cheapest and dearest markets averages 5.8 points per year, and over decades that difference compounds into a very large gap in wealth. Why this matters: the price you start at shapes what you earn.

Against 5-year returns, the regression line slopes down: higher starting valuations mean lower future returns.

Every point of CAPE paid up front came out of the next 5 years.

One dot per month, April 2006 to February 2016: the starting valuation against the annualised total return over the following 5 years. The fit explains 61% of the spread.

Scatter of starting CAPE against annualised return over the following five years, 119 monthly observations, with a downward fit line: each extra point of CAPE cost 0.49 per cent a year, r squared 0.61

Across: CAPE at the start · Up: Annualised return over the next 5 years · 119 observations

Each extra point of CAPE, 0.49% a year less over the next 5 · r² 0.61 · Bought at the December 2007 peak, the index had gone nowhere 5 years later

Nifty 500 CAPE 10 and Total Return Index · Apr 2006 to Feb 2016

Over 10 years the link is even clearer, because shorter horizons are pushed around more by shocks and cycles.

Stretch the horizon to 10 years and valuation still sets the ceiling.

The same starting months, with returns measured over the following decade. The slope is gentler because 10 years has more time to average out a bad entry, but the ordering holds and the fit is tighter.

Scatter of starting CAPE against annualised return over the following ten years, 119 monthly observations, with a downward fit line: each extra point of CAPE cost 0.27 per cent a year, r squared 0.64

Across: CAPE at the start · Up: Annualised return over the next 10 years · 119 observations

Each extra point of CAPE, 0.27% a year less over the next 10 · r² 0.64 · Even from the 2007 peak, a decade returned 7% a year. From the cheapest fifth, twice that.

Nifty 500 CAPE 10 and Total Return Index · Apr 2006 to Feb 2016

Why High Prices Can Stay High

Expensive does not always mean overdue for a fall. A lot depends on how much money is around. When the RBI cuts rates, banks and bonds pay less, so savers move into equities, and the more money flows in, the higher prices go. That is why markets usually do well when borrowing is cheap and struggle when that reverses.

India has an extra push: over the past decade, families have been moving savings out of gold, property and fixed deposits into mutual funds and SIPs, which sends a steady stream of domestic money into stocks every month.

Prices can also stay high because investors expect much bigger profits from big shifts like new technology, reforms or population trends, such as today's excitement about artificial intelligence. The longest stretches of high valuation come when easy money, strong growth expectations and a widely believed story all feed each other, keeping prices up far longer than seems reasonable. But when those assumptions crack, prices can fall just as far as they rose.

Sources

Every figure comes from IIM Ahmedabad's India CAPE data and NSE's index returns.

Data

Research papers

Official releases