Indian Markets at Valuation Extremes: CAPE, Yield Curve Signals, and Market Outlook

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio, developed by Nobel laureate Robert Shiller, smooths out business cycle fluctuations by using 10 years of inflation-adjusted earnings. This gives us a clearer picture of market valuations than traditional P/E ratios.

My Investment Prediction from June 9, 2025: As someone who closely tracks market valuations using the Shiller CAPE ratio, I suggested on June 9, 2025 that Indian markets would face corrections soon due to extreme valuations. While markets only fell modestly (-0.62% in one week, -1.53% max drawdown over one month), the correction I predicted is still unfolding.

What is CAPE and Why It Matters

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio, developed by Nobel laureate Robert Shiller, smooths out business cycle fluctuations by using 10 years of inflation-adjusted earnings. This gives us a clearer picture of market valuations than traditional P/E ratios.

Key CAPE Insights for India:

• Current Nifty 500 CAPE (June 2024): 43.8 - in the 98th percentile of historical distribution
• Historical mean since April 2006: 34.3 with standard deviation of 7.9
• Only the 2008 and 2015 peaks were higher than current levels

Historical Evidence: High CAPE = Poor Returns

When I analyze the data from the research paper by Jacob and Raju (2024), the evidence is crystal clear:

Returns by CAPE Quintiles (Nifty 100):

• Q1 (Low CAPE): 30.0% average 1-year returns, -11.8% max drawdown
• Q5 (High CAPE): -0.3% average 1-year returns, -27.8% max drawdown

Risk Increases Dramatically:

• Probability of negative returns when CAPE is in highest quintile: 39.4%
• Average recovery time after high CAPE periods: 219+ days
• Maximum drawdowns can reach -59% to -73% over 10-year periods

Historical relationship between CAPE levels and Indian market performance showing returns and drawdowns

Historical relationship between CAPE levels and Indian market performance showing returns and drawdowns CAPE and Market Movement Correlation Below is the historical relationship between NIFTY index movements and CAPE valuations from 2006 to 2024. Notice how the three major CAPE peaks (2008, 2015, and 2024) corresponded with subsequent market corrections or periods of subdued returns.

Historical comparison of NIFTY 50 Index movements with Shiller CAPE ratio showing valuation extremes and subsequent market corrections AI Bubble and Global Factors The current Indian market situation mirrors global concerns about an AI investment bubble:

1. Zoho's Sridhar Vembu warns: Current AI boom makes him "very uncomfortable" due to unprecedented investment levels.
2. IMF comparison: AI bubble could burst similar to dot-com crash of 2000
3. Wall Street alarm: Goldman Sachs and analysts warn of "priced to perfection" valuations Trump's Impact on Yield Curves

• Pressure on Federal Reserve to lower 10-year yields through tariff threats
• Yield curve inversions historically precede recessions by 7-18 months​
• Global inversions trigger capital outflows from emerging markets like India