SSRN Id3156574 PDF

April 4, 2018 Quantitative Finance jubilee
To appear in ..., Vol. 00, No. 00, Month 20XX, 1–35
Jubilee Tectonic Model: Forecasting Long-Term Growth

and Mean Reversion in the U.S. Stock Market
Stephen H.-T. Lihn†
(v1.0, Released on April 4, 2018)
We propose a long-term forecast model based on linear growth and mean reversion characteristics in the
U.S. stock market. It can forecast future returns of the stock market, Treasury yield, and gold price.
The “jubilee” name comes from its optimal trend-following window of 45 years. The “tectonic” name
comes from the hypothesis that there are fault lines in the historical CAPE, which can be calibrated and
corrected through statistical learning. The tectonically adjusted log-CAPE can be fully decomposed by a
four-factor regression: two from mean reversion, two from inflation. This regression explains the mystery
of lofty CAPE. These five factors form the forecast model for the 10 and 20-year future equity returns
with high R-square above 80%. Major fault lines in CAPE are identified in each equity forecast model. We
also analyze the causality in which the equity cycle leads both the Treasury yield and real gold price by
74 and 30 months. Therefore, their near-term direction can be predicted by extrapolating the regression.
For longer horizon, we apply the factor model to forecast Treasury’s 20-year future yield and gold’s 20-
year real return. A parsimonious triangular wave model is constructed to explain the periodicity of mean
reversion in the past century. We conclude that the channel deviation is an universal mean-reversion
variable among the three major asset classes.
Keywords: forecast model; economic cycle; mean reversion; CAPE; stock market; interest rate; gold
JEL Classification: C38; C53; E32; E37; E47
1. Introduction
The U.S. stock market has exhibited amazing resilience in the long term. In the past 200 years, it has
produced a consistent real return of about 6.6% per year (Figure 2.1 and Siegel (2014)). However,
this wonderful return comes with many ups and downs. In some cases, the market could go down
more than 50%, and be stagnant for more than a decade. The longest and largest drawdown in
history was from 1929 to 1948. And more recently, the peak reached in 2000 had not been surpassed
until 2012. Making things more intricate, these two bear markets were preceded by two strongest
ten-year bull markets in history. How do we make sense of them? More importantly, are they
forecastable? In an interview with CNBC1 , Warren Buffett said, “Consistently buy an S&P 500
low-cost index fund, I think it’s the thing that makes the most sense practically all of the time.”
What is the rationale behind this statement? How much faith should we have in it? This paper is
intended to answer some of these questions in an econometric setting.
† I am greatly indebted to Professor John Mulvey for his guidance and discussions that lead to this work. Corresponding au-
thor. Email: stevelihn@gmail.com; LinkedIn: https://www.linkedin.com/pub/stephen-horng-twu-lihn/0/71a/65. Stephen Lihn

is managing director at Novus Partners, Inc.. Disclaimer: The views in this paper are solely the responsibility of the author.
They don’t reflect the views of the company, nor does this paper contain any propietory data from the company.
1 https://www.cnbc.com/2017/05/12/warren-buffett-says-index-funds-make-the-best-retirement-sense-practically-all-the-
time.html
Electronic copy available at: https://ssrn.com/abstract=3156574

Recent application of trend filtering technique has revealed linear characteristics of market trends
(Mulvey, Hao, and Li (2017)). In the short term, the market process is highly lepkurtotic (kurtosis
3) and influenced heavily by the underlying volatility process (Lihn (2017d)). In the long term,
however, the market process is not a random walk process. It is a mean-reverting process with linear
growth. More interestingly, when the time horizon is extended to decades, the mean-reverting
process is slightly platykurtic (kurtosis < 3), which is strikingly different from the lepkurtotic
random walk process observed in the short term.
With such conceptual framework, we develop an algorithm that separates the mean-reversion
component from the linear growth component in the market process. The mean-reversion component
turns out to be associated with the “cyclically adjusted P/E ratio”, aka CAPE (Campbell and
Shiller (1988)), in a profound way. The nickname of our model is called “jubilee tectonic model”.
The “jubilee” name comes from its optimal trend-following window of 45 years. The “tectonic” name
comes from the hypothesis that there are fault lines in the historical CAPE, which can be calibrated
and corrected in this model through statistical learning. Such “model breaks” have been categorically
discussed in Chapter 19 of Elliot and Timmermann (2016). We apply a more restrictive approach
to capture these breaks, and attempt to give them economic interpretation.
The forecast of future equity return is an important topic for policy makers and asset allocators.
Research from Vanguard (David, Aliaga-Diaz, and Thomas (2012)) found that “many commonly
cited signals have had very weak and erratic correlations with actual subsequent returns.” CAPE
remains one of the most powerful predictors. Even then, it has explained only about 34% of the
time variation1 . Recent forecasts using CAPE have been over-pessimistic. The lofty CAPE issue
continues to trouble the academic community, as Shiller (2018a) wrote on Project Syndicate: “It is
impossible to pin down the full cause of the high price of the U.S. stock market.” In an attempt
to address such issue, Siegel (2016) studied six variations: reported earnings, operating earnings,
and NIPA profits, in combination with price index portfolio and total return portfolio. The R2
was increased from 34% to 40% in the best case scenario. In this paper, the tectonically adjusted
CAPE, plus mean reversion and inflation, form the five-factor econometric model that forecasts
equity returns with R2 above 80%. And we expand our factor model to forecast 10-year Treasury
yield (GS10) as well as real gold price.
1.1. Background
This research is a continuation from Lihn (2017d) and Lihn (2018). Here we briefly introduce the
background that motivated this paper.
Formerly, we studied the daily fluctuation of the market process and its stationary distribution.
The study culminated in a stochastic framework for the joint modeling of SPX and VIX (Lihn
(2018)), in which the Weiner noise W (t) is replaced by the Laplace noise L (t). Let X (t) be the
log-price process of SPX, and σ (t) the VIX spot process. The daily increments of X (t) and σ (t)
are subject to the following pair of stochastic processes:
∆X (t) = η (νbear − σ (t)) ∆t + η 0 σ (t) ε1 +? (X (t) − [long term trend])?,

σV2 p (1.1)
∆σ (t) = (ν0 + 6θ − σ (t)) ∆t + σV max (σ (t) − ν0 , δν0 ) ε2 ,
8θ
p
where ε = Σ b ∆L (t) is the bivariate Laplace noise. This is a complex system with many param-
eters, which are explained in footnote 2 . The reader needs not to understand it for this paper. The
1 The 40% R2 cited in David, Aliaga-Diaz, and Thomas (2012) is a result of truncating the CAPE data prior to 1926.
2 The ∆σ (t) equation is a modified CIR process (Cox, Ingersoll, and Ross (1985)), where ν0 is the floor volatility for VIX, θ
is the volatility bandwidth, and σV is the volatility of volatility. νbear is the level of VIX for bear market reversal, η is the
Electronic copy available at: https://ssrn.com/abstract=3156574

main point here is that, for daily increment ∆t = 1/252, ∆X (t) and ∆σ (t) can fit the leptokurtic
daily distributions of SPX and VIX with high precision. The expected return of ∆X (t), its standard
deviation, skewness, and kurtosis all match empirically. But when we simulate the time evolution
of X (t), it can not stay in the trend line. After a few years, it deviates from that trend. That is,
it has too much random walk. This is the puzzle marked as “? (X (t) − [long term trend])?” in the
first part of Eq. (1.1).
This led us to consider adding the generalized mean-reverting process to the system (Section 1
of Lihn (2017d)),
sgn (X (t) − µ) σL2

dX (t) = −θ0 dt + σL dW (t) , where θ0 = 2 . (1.2)
|X (t) − µ|1−2/λ σλλ
In this equation1 , µ should represent such “long-term trend” that can guide X (t) on the right
track. But we must first understand what µ (t) = [long term trend] is. This was what motivated the
research presented in this paper. In addition, the ability to target an arbitrary kurtosis in Eq. (1.2)
(by tuning λ) provides the conceptual flexibility needed to determine the optimal trend-following
window in Section 2.4 of this paper.
1.2. Main Results and Organization of The Paper

The mean-reversion decomposition of the stock market index is described in Section 2. We define a
causal framework based on trend-following channel, from which we calculate the channel moving
average α (t), channel return R (t), and channel deviation Y (t). These three quantities are
the foundation of this paper. And we propose a method to determine the optimal look-back period
of the channel.
In Section 3, we study the relation between such framework and 10-year log-CAPE,
log (CAPE10 (t)), which is decomposed in a four-factor model consisting of Y (t), R (t), and the
10 and 20-year log-returns of CPI: CPI10 (t) and CPI20 (t). The concept of fault lines in log-CAPE
is introduced by hypothesizing that log-CAPE should have near-perfect regression in the four-factor
model. Log-CAPE is piece-wise continuous, but allowed to have discontinuities at a few points in
time (∆i log CAPE10 at tadj
i ). We borrow the terminology from plate tectonics, and call it “the
tectonically adjusted CAPE”, or simply “tectonic CAPE”. Thus this model states that
(
0, X t < tadj
i ;
log CAPEadj
10 (t) = log (CAPE 10 (t)) + adj
∆i log CAPE10 , t ≥ ti .
i=1···N (1.3)

log CAPEadj
10 (t) ∼ β0 + β1 Y (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) + ε.
The lofty CAPE (Shiller (2014) and Shiller (2018a)) is explained by the above regression with
R2 = 96% for N = 4.
In Section 4, we build a parsimonious triangular wave model to explain the periodicity observed
in the U.S. stock market. This simple model captures the main features in the 10-year and 20-year
volatility-to-return conversion factor for X (t), η 0 is the spot vs realized adjustment factor for the volatility of X (t). We note
that ν0 + 6θ is the long-term mean of σ (t) due to the stationary quartic stable count distribution. The δν0 term is a small
positive number, typically a small fraction of ν0 , that prevents the volatility of volatility term from hitting zero. ε is a bivariate
noise, generated from the 2D correlation matrix Σ b and the bivariate Laplace noise L (t).
1 µ is the mean-reversion level, σ
L is the local volatility. In the context of the lambda distribution, σ defines the standard
1
−1 2 −2
deviation of X (t), which is σ Γ 3λ 2
Γ λ2
, and λ defines the kurtosis of X (t), which is Γ λ2
Γ 5λ2
Γ 3λ 2
.
nominal returns, and provide an intuitive guide for the rest of the paper.
In the second part of the paper, we lay out the general form of the tectonic forecast model in
Section 5, such as
(
X 0, t < tadj
i ,
∆=
∆i , t ≥ tadj
i ;
i=1···N (1.4)
X
rf,∆Tf (t) ∼ β0 + βk fk (t) + ∆ + ε,
k=1···5
where rf,∆Tf (t) is the forward log-return of period ∆Tf that we intend to forecast;
{fk } are the
factors under consideration: Y (t) , R (t) , CPI10 (t) , CPI20 (t), log CAPE∆Tf (t) ; and {∆i } are the
faults in the generic form.
We aim to forecast the 10 and 20-year forward SPX returns. We start with amending Shiller’s one-
factor model with tectonic CAPE in Section 6. Then we explore the five-factor model that forecasts
the nominal returns in Section 7. With low single digit N , these models can achieve substantially
higher R2 and lower standard error ε.
Our models produce different predictions for the future: The original CAPE model predicts below
average real returns for the next decade. But our models predict much higher returns for the next
decade, and very positive outlook for the next 20 years.
The exploration of equity forecast model is wrapped up with an experimental four-factor model
that doesn’t include log-CAPE in Section 8. We show that the equity forecast model can exist with-
out valuation metrics involved. This is contrary to the common belief in the academic community.
We then apply the factor model to the 10-year Treasury yield in Section 9, and the gold price in
Section 10. We discover that both Treasury and real gold price have cycles that coincide with the
equity cycle, but lagged by 74 and 30 months respectively. The Treasury cycle is further complicated
by the concept of the optimal yield, which causes equity returns to accelerate when the yield moves
towards the optimal yield, and vis versa.
1.3. Source of Data

Our data comes from several sources. The main data source is from Shiller’s online data website
(Shiller (2018)). The excel file “ie_data.xls” contains monthly averaged prices, dividends, and earn-
ings of SPX since 1871. It also contains consumer price index (CPI) and 10-year Treasury yield
(GS10). It derives the real prices, real dividends, and real earnings, and calculates the 10-year
CAPE.
The second data source is from Schwert (1989), from which we obtain the stock market total
return data since January of 1802.
The third data source is the annual CPI data since 1800 from Minneapolis FED (2018).
The fourth data source is from FRED (2018), which provides daily and/or monthly online updates
for the 3-month interest rate (TB3MS), GS10, and gold prices. The difference between 3-month and
10-year interest rates forms the yield spread (since 1920). The yield spread inversion is one of the
two indicators for stock market crash in the short term (5-year horizon), which will be shown in
conjunction with our equity forecast charts. (The other indicator is the persistently high stock
market volatility.)
2. Mean-Reversion of The U.S. Stock Market
2.1. Total Return Index

We first define the methodology of calculating stock market’s logarithmic total return index (TRI).
Assume the market index at time t is p (t) and pays dividend d (t) for period ∆t. For the long-term
analysis, we work with monthly interval ∆t = 1/12. The total backward log-return for period ∆t is
r (t + ∆t) ≡ log (p (t + ∆t) + d (t)) − log p (t). And let CPI (t) be the consumer price index (CPI)
at time t, we construct the nominal and real TRI in logarithmic scale as
X
X (t) = r (τ ) , nominal TRI;
t1 ≤τ ≤t (2.1)
Xreal (t) = X (t) − log CPI (t) , real TRI.
where {τ } represents all the months available to our analysis, and t1 is the inception date of the
data, 01/1802.
The above notation of X (t) is the “continuous notation”. Empirically, t is discrete. We fol-
low Shiller’s convention that each month is identified by the time fraction of ti = y (ti ) +
(m (ti ) + 1/2) ∆t, where i = 1, 2, 3, · · · is an integer label, y (t) is the calendar year, and m (t)
is the month of the year (m (t) = 0 for January). Thus the “discrete notation” states that, at time
ti , the logarithmic index value is Xi . We use both notations depending on the context and the
cleanliness of expression.
Panel (1) of Figure 2.1 shows X (t) of the U.S. stock market since 01/1802. The linear trend is
obvious, but slightly concave. There are ups and downs, a few of them are quite large. For instance,
one in 1860’s, one in 1930’s, then in 1960-1970’s, and more recently in 2000’s.
Panel (2) shows the more common view in the literatures: the real logarithmic total return index
Xreal (t) (This reproduces Figure 5-4 in Siegel (2014)). The most notable feature is that Xreal (t)
can be linearly regressed over the 200-year history, with an impressive R2 = 0.994. The slope is
about 6.55% per year (between 1802 and 2017), which is called the real equity risk premium
over inflation. This constant is one of the most celebrated constants in modern financial systems.
However, we must note that no other major equity index exhibits such beautiful linearity over
such long history. Geopolitical events, financial bubbles and crashes often cause significant distortion
or even disruption to many national indices. Some people may even criticize that the linearity of
Xreal (t) for SPX carries with it a strong survivorship bias. There is no certainty that it will continue
to work, although it has been working quite well for two centuries.
We also note that, on the back of such impressive R2 is the standard error of 0.317; thus its
2-stdev is 0.63. That is, the market will swing ±0.63 to each direction in logarithmic scale. This
huge amount of volatility is disguised in the semi-log plot. And this paper is for the study of such
disguised “fine structure”.
2.2. Mean-Reversion Decomposition

For a given time series that is predominantly in a linear trend, such as X (t), we assume it is
composed of a linear process and a mean-reverting process. We propose the following algorithm to
decompose the two processes while maintaining causality. Let ∆Tb be the duration of the look-back
channel. At time T , we apply linear regression
X (t) ∼ α (T ) + R (T ) (t − T ) , where t ∈ [T − ∆Tb , T ] , (2.2)

(1) Nominal logarithmic total return index of SPX

15
10
X(t)
5
0
1800 1850 1900 1950 2000
t (year)
(2) Real logarithmic total return index of SPX
Slope = 0.0655 (real equity premium)

10
R2 = 0.994
std err = 0.3167
Xreal (t)
log(CP I)
0
1800 1850 1900 1950 2000
t (year)
Figure 2.1. Panel (1) The nominal total return index for the U.S. stock market X (t) in logarithmic scale since 1802.
Panel (2) shows the real total return index Xreal (t). The slope 6.55% is the long-term real equity premium over
inflation. The linear regression has an impressive R2 = 0.994 with the standard error of 0.317.
to obtain α (T ), which is called channel moving average (CMA), and R (T ), which is called
channel return. Then we derive the channel deviation at time T as Y (T ) = X (T ) − α (T ). One
can view Y (T ) and α (T ) as the decomposition of X (T ), where α (T ) is linear and non-stochastic,
and Y (T ) is mean-reverting. R (T ) is the instantaneous rate of change of α (T ).
Y (T ) is of paramount importance in this paper. We will show that log-CAPE mean-reverts in
similar pattern and scale to Y (T ) in Section 3. For 10-year Treasury yield, the mean-reversion
quantity G (t) defined in Eq. (9.3) moves as 12 − 12 Y (T ) with a lag. Gold’s real log-price mean-
reverts as 1 − Y (T ) in Section 10. Y (T ) appears to be the universal driving force for three major
asset classes: equity, bond, and precious metal.
Note that α (T ), R (T ), and thus Y (T ) are causal, they can be used for forecasting after time T .
2.3. Closed Form Solution

There are closed form solutions for α (T ), R (T ), and Y (T ) in the discrete notation. Eq. (2.2)
is simply the ordinary least squares (OLS) optimization. Let hti − T i be the mean of ti − T for
ti ∈ [T − ∆Tb , T ], and N is the sample size of ti , we have hti − T i = N 2+1 ∆t ≈ − 12 ∆Tb , and
N →∞
1 1
Var (ti ) = 12 N 2 + N ∆t2 ≈ 12 ∆Tb2 . Then
N →∞
√
Cov (Xi , ti ) Stdev (Xi ) 12
R (T ) = = Cor (Xi , ti ) ≈ Cor (Xi , ti ) Stdev (Xi ) ,
Var (ti ) Stdev (ti ) N →∞ ∆Tb
s
N +1 (2.3)
α (T ) = hXi i − R (T ) hti − T i = hXi i + 3 Cor (Xi , ti ) Stdev (Xi )
N
1
≈ hXi i + R (T ) ∆Tb .
N →∞ 2
As we can see, the main feature in R (T ) and α (T ) is the covariance between Xi and ti in the
channel. Given the same Stdev (Xi ), R (T ) is maximized by the best Cor (Xi , ti ), which is 1 when
Xi is perfectly linear to ti .
α (T ) is the result of the optimal linear predictor. The first term in α (T ) is the moving average
hXi i. The second term introduces the “correction”, which is non-zero as long as Cor (Xi , ti ) 6= 0.
The sign of the “correction” is given by the sign of Cor (Xi , ti ).
Eq. (2.3) leads to the closed form of the channel deviation,
s
N +1
Y (T ) = X (T ) − hXi i − 3 Cor (Xi , ti ) Stdev (Xi ) (2.4)
N
This equation is out-of-sample, thus is causal. But for the beginning of the history (or when the
historical data is shorter than ∆Tb ), there isn’t enough data to preserve the causality of Y (T ).
We can simply ignore the beginning period for SPX since this period is in the 1850’s, which is
almost inconsequential for forecasting 2018 and beyond. However, it can be a problem for many
stock markets that started in 1960’s and 1970’s. E.g. the Chinese stock market only has history
since early 1990. In these cases, we can calculate the in-sample (t ≤ T ) channel deviation as
s
N +1
in sample : Y (t) = R (T ) (t − T ) + X (t) − hXi i − 3 Cor (Xi , ti ) Stdev (Xi ) (2.5)
N
kurtosis of Y (T ) skewness of Y (T )
8
0.2
7
skewness
6
kurtosis
-0.2
5
4
-0.6
3
2
10 20 30 40 50 60 10 20 30 40 50 60
∆Tb ∆Tb
Figure 2.2. Optimization of the look-back channel ∆Tb . The left panel shows the kurtosis of Y (T ) forms a plateau
around 2.5 when ∆Tb > 35. The right panel shows the skewness of Y (T ) crosses zero at ∆Tb = 45, which we choose
to be the optimal look-back period.
One must keep in mind that the in-sample result is not causal. (It can also be used for out-of-sample
time t > T as an extrapolation!)
2.4. Optimal Choice of Look-back Channel at 45 Years

One of the most important tasks in this part of the model is to determine the look-back channel
∆Tb . Based on our empirical experimentation, we know it is between 40 and 50 years. We provide
one version of optimization that we use to determine ∆Tb = 45.
For a given ∆Tb < 60, we calculate Y (T ) for all T ’s between 01/1862 and 12/2017. We then
calculate the skewness and kurtosis of Y (T ) for such ∆Tb . We seek the optimal ∆Tb between 10
and 60 that produces the lowest kurtosis and zero skewness with a tolerance of randomness. The
kurtosis and skewness are shown in Figure 2.2.
This turns out to be a relatively simple optimization problem to solve. When ∆Tb is small, the
kurtosis is very high and the skewness is negative. As ∆Tb increases, the kurtosis decreases towards
3 and the skewness increases towards zero. When ∆Tb > 21, the kurtosis decreases below 3, that
is, the system transitions from lepkurtotic to platykurtic. When ∆Tb > 35, the kurtosis forms a
plateau around 2.5. The kurtosis reaches its minimum of 2.445 at ∆Tb = 39, but the skewness
doesn’t cross zero until ∆Tb = 45 at which point the kurtosis is at 2.498, slightly higher than the
absolute minimum. We determine that ∆Tb = 45 is the optimal choice that we seek.
Figure 2.3 shows the result of α (T ), Y (T ), and R (T ) at ∆Tb = 45. We first note that Y (T )
oscillates between ±0.5 with a periodicity of approximately 40 years. The periodicity is particular
clear by observing the legs of Y (T ). The market swings violently during two periods: From 1929 to
1933, the oscillation almost reaches ±1.0. From 2000 to 2009, the oscillation is as large as ±0.75.
We will elaborate more on the periodicity and amplitude of Y (T ) in Section 4.
Secondly, we observe that R (T ) has three plateaus in history. The first plateau is at 5% before
1860. The second plateau is at 7.13% from 1880 to 1950. The third plateau is at 10.52% from 1970
to now. The values of plateau are determined by zeroth order genlasso::trendfilter utility in
R1 . At 600 degrees of freedom, we round the output of beta to 3 digits, and select the largest
clusters of beta that have repeated more than 50 months. The average of beta from each cluster is
1 See also https://cran.r-project.org/web/packages/genlasso/vignettes/article.pdf

the mean of the plateau. The 10.52% return of the third plateau is often quoted in the literatures
and media as the long-term expected return of SPX. Here we provide a proper context in terms of
R (T ).
There are two other methods that can be used to determine the optimal ∆Tb . But none of them
conforms to a maximization problem as the one we show above. Nevertheless, they show the rich
structure behind the model, thus deserve to be mentioned:
The second method is to minimize the standard deviation of R (T ) using a penalty parameter.
The need for a penalty parameter is that the standard deviation is always decreasing with larger
∆Tb . Thus we must set a limit on the optimization.
The third method is to calculate Granger causality for Y (T ) ∼ R (T ). ∆Tb must be large enough
such that R (T ) does NOT cause Y (T ) since R (T ) is supposed to be the linear growth component
and Y (T ) is supposed to be the mean-reverting component.
3. Relation to CAPE and CPI
In this section, we show that Y (t) and R (t) are closely related to CAPE and CPI, even though
their data generating processes (See Chapter 1 of Elliot and Timmermann (2016)) don’t seem to be
related at all. We discover that the log-CAPE can be decomposed by a four-factor model with a high
R2 . We introduce the concept of tectonic CAPE, in which we hypothesize wars and national policy
changes in the past might have resulted in significant dislocations in the data generating processes
of CAPE and CPI. We use nonlinear optimization technique to uncover these dislocations, that we
call “fault lines”. However, we do this only sparingly so that we don’t overfit the data.
3.1. Decomposition of log-CAPE

Let CAPE10 (t) denote the 10-year CAPE. And let CPI10 (t) and CPI20 (t) denote the 10 and
20-year log-returns of CPI. That is,
log CPI (t) − log CPI (t − ∆T )

CPI∆T (t) = . (3.1)
∆T
We perform the following linear regression for t between 1/1881 and 12/2017:
log (CAPE10 (t)) ∼ β0 + β1 Y (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) + ε, (3.2)
which results in a high R2 of 0.77. This is shown in Panel (3) of Figure 3.1. The summary of linear
model from R is shown below:
1 a ← lm(log.cape10 ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 + cpi.logr.20 , data=df)
2 summary(a)
1
2 Call:
3 lm(formula = log.cape10 ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 +
4 cpi.logr.20, data = df)
5
6 Residuals:
7 Min 1Q Median 3Q Max
8 -0.45335 -0.16846 -0.00139 0.16805 0.42302
9
10 Coefficients:
10
(1) Channel moving average

15
X(T )
α(T )
X(T ), α(T )
10
5
0
1800 1850 1900 1950 2000
T (year)
(2) Channel deviation

1.0
0.5
Y (T )
0.0
-0.5
-1.0
1800 1850 1900 1950 2000
T (year)
(3) Channel return

0.12
0.10
s2 = 0.1052
R(T )
0.08
s1 = 0.0713
0.06
s0 = 0.0500
0.04
1800 1850 1900 1950 2000
T (year)
Figure 2.3. Optimally decomposed α (T ), Y (T ), and R (T ) at ∆Tb = 45. The legs of Y (T ) are drawn in red circles
in Panel (2) to illustrate the periodicity. The levels of plateau in R (T ), s0 = 0.05, s1 = 0.0713, s2 = 0.1052, are
calculated from zeroth order genlasso::trendfilter utility. The 10.52% of s2 is often quoted as the long-term
expected return of SPX.
11
11 Estimate Std. Error t value Pr(>|t|)

12 (Intercept) 1.23464 0.02919 42.30 <2e-16 ***
13 eqty.lm.y 0.79249 0.01655 47.88 <2e-16 ***
14 eqty.lm.r 20.20811 0.36337 55.61 <2e-16 ***
15 cpi.logr.10 -5.27040 0.27650 -19.06 <2e-16 ***
16 cpi.logr.20 -5.88730 0.38396 -15.33 <2e-16 ***
17 ---
18 Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
19
20 Residual standard error: 0.1904 on 1638 degrees of freedom
21 (948 observations deleted due to missingness)
22 Multiple R2 : 0.7741, Adjusted R2 : 0.7735
23 F-statistic: 1403 on 4 and 1638 DF, p-value: < 2.2e-16
All four factors are highly significant. That is, more than three quarters of information in log-
CAPE is contained in the linear combination of total price mean reversion and past inflation.
3.2. Lofty CAPE?

We illustrate the inner workings of the four-factor regression by Panel (1) and Panel (2) of Figure
3.1. Panel (1) shows the log (CAPE10 (t)) centered by its own mean (blue) vs. Y (t) (red). We
observe that log (CAPE10 (t)) is almost in the same scale as Y (t), and this is confirmed by the
coefficient β1 = 0.79 in Eq. (3.2).
There are times that log-CAPE moves below Y (t) (e.g. in 1920’s, 1950’s, and early 1980’s) and
times that log-CAPE moves above Y (t) (e.g. in 1900’s and 2000’s). Their differences are made up
by CPI10 (t) and CPI20 (t). This is confirmed by the negative correlation (β3 = −5.3 and β4 = −5.9)
in the summary statistics above. This is shown graphically in Panel (2), where R (t) is shown in
blue line. CPI10 (t) (red) and CPI20 (t) (purple dotted) are shifted by the real equity premium of
6.55%. We observe that, when CPI10 (t) and CPI20 (t) move above R (t), Y (t) tends to be above
log (CAPE10 (t)) , and vis versa.
This anti-correlation between log-CAPE and inflation is one of the two main reasons why CAPE
is perceived at lofty level since 2000. The high CAPE reading is a reflection of ultra-low inflation
in the past two decades.
The second reason is that log-CAPE is positively correlated to R (t) with β2 ≈ 20. Since R (t)
is currently at the third plateau, it also contributes to the high level of CAPE. From 1950 to
1970, the market was transitioning from the second plateau to the third, the difference in R (t) is
s3 − s2 ≈ 3.4%. Multiplying it by β2 ≈ 20, its impact on log-CAPE is 0.68, which is translated to
97% higher CAPE. In 1970’s and 1980’s, this effect was muted because of the high inflation. Going
into 1990’s, the high tide of inflation receded and CAPE began to move much higher.
We conclude that the lofty CAPE can be explained by the four-factor regression model reasonably
well.
3.3. Tectonic CAPE

The 77% of R2 in the four-factor regression indicates there are still 23% of information not captured
yet. In Panel (3) of Figure 3.1, small deviations between the blue line and red line can be observed.
We hypothesize that historically CAPE has been distorted at various times due to national policy
changes and/or major wars (Chapter 19 of Elliot and Timmermann (2016)). At a specific time tadj i ,
the amount ∆i log CAPE10 should be added to log (CAPE10 (t)). These adjustments are called the
“fault lines”, and the adjusted CAPE is called “tectonic CAPE”.
Formally, the tectonically adjusted log-CAPE and the regression are
12
(1) log(CAP E 10 (t)) (centered) vs Y (t)

log(CAP E 10 (t)) (centered)
1.0
Lofty CAPE !
log(CAP E 10 (t)) (centered)
Y (t)
0.0
-1.0
1800 1850 1900 1950 2000
t (year)
(2) R(t) and CPI log-returns CP I 10 (t) and CP I 20 (t)

0.00 0.05 0.10 0.15
R(t)
CP I 10 (t) (shifted)
R(t)
CP I 20 (t) (shifted)
Low inflation
1800 1850 1900 1950 2000
t (year)
(3) Four-factor regression of log(CAP E 10 (t))
R2 = 0.774
3.5
Lofty CAPE ?
log(CAP E 10 (t))
log(CAP E 10 (t)) std err = 0.1904

regression
2.5
1.5
1800 1850 1900 1950 2000
t (year)
(4) Four-factor regression of tectonic CAPE with 4 fault lines

3.0
R2 = 0.962
10 (t))
log(CAP E adj
10 (t)) std err = 0.0759
log(CAP E adj
regression
2.0
1894.380 1937.780 1986.420 2009.260

∆ = -0.508 ∆ = 0.223 ∆ = -0.378 ∆ = -0.122
1.0
1800 1850 1900 1950 2000
t (year)
Figure 3.1. Linear regression of 10-year log-CAPE by the four factors: Y (t), R (t), CPI10 (t) and CPI20 (t). Panel (1):
Comparison of centered log-CAPE and Y (t) shows they are similar and in the same scale. Panel (2): R (t), CPI10 (t)
and CPI20 (t) can supplement the differences between log-CAPE and Y (t). Here CPI10 (t) and CPI20 (t) are shifted
by the real equity premium. Panel (3): The mystery of loft CAPE can be explained by the low inflation and high
R (t) in the four-factor model. Panel (4) introduces the concept of tectonic CAPE that makes further correction to
the four-factor model.
13
i tadj
i ∆i log CAPE10 Note
1 1986.42 -0.378 This is the most important adjustment in modern history. It
is obviously associated with 1986 Tax Reform Act.
2 1894.42 -0.508 This is the largest adjustment here, but it is far in the past.
Available data before this date is very short.
3 1937.78 0.223 This is a major fault line dividing the pre-WWII and
post-WWII era.
4 2009.26 -0.122 This is related to the 2008 financial crisis and the massive
federal stimulus that followed. But its magnitude is not as
large as the other three.
Table 3.1. The four fault lines of log-CAPE in the four-factor model, Eq. ( 3.2).
(
X 0, t < tadj
i ;
log CAPEadj
10 (t) = log (CAPE10 (t)) + adj
∆ log CAPE , t ≥ t i .
i=1···N i 10 (3.3)

log CAPEadj
10 (t) ∼ β0 + β1 Y (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) + ε.
The objective is to minimize the AIC of the regression in Eq. ( 3.2) with the optimal set of tadj i
and ∆i log CAPE10 , i = 1 · · · N , where N is the number of fault lines 1 . Each fault line adds two
variables to the model, thus should be penalized by AIC (or BIC). By increasing N , we can locate
the fault lines from the largest to the smaller ones. However, to avoid over-fitting, we advise the
smaller N , the better (Section 6.1 of Elliot and Timmermann (2016)).
Four major fault lines are identified in Table 3.1. The R2 is as high as 0.96, as shown in Panel
(4) of Figure 3.1. That is, we’ve successfully decomposed 10-year log-CAPE close to 100% by Y (t),
R (t), CPI10 (t) and CPI20 (t).
The ∆i log CAPE10 adjustments are not quite the same as the “model breaks” in Chapter 19 of
Elliot and Timmermann (2016), where the regression coefficients are allowed to change between
different time periods. Our model is more restrictive. We don’t allow regression coefficients to
change. ∆i log CAPE10 ’s are constants added to log-CAPE. Therefore, we are in effect multiplying
the earnings by constants across fault lines.
The summary statistics from R is shown below:
1 b ← lm(log.cape10.adj ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 + cpi.logr.20 , data=df)
2 summary(b)
1
2 Call:
3 lm(formula = log.cape10.adj ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 +
5
6 Residuals:
8 -0.233195 -0.041219 0.006204 0.047853 0.258799
9
10 Coefficients:
1 An alternative formulation of the linear regression is to place Y (t) on the right hand side. It has the benefit of stabilizing the
regression since the adjustments ∆i log CAPE10 must be bounded by Y (t).

Y (t) ∼ β0 + β1 log CAPEadj 10 (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) + ε. (3.4)
14

12 (Intercept) 0.858400 0.011637 73.76 <2e-16 ***
13 eqty.lm.y 0.949174 0.006599 143.84 <2e-16 ***
14 eqty.lm.r 20.613188 0.144867 142.29 <2e-16 ***
15 cpi.logr.10 -2.558873 0.110235 -23.21 <2e-16 ***
16 cpi.logr.20 -12.906417 0.153074 -84.31 <2e-16 ***
17 ---
18 Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
19
23 F-statistic: 1.032e+04 on 4 and 1638 DF, p-value: < 2.2e-16

Notice that β1 = 0.95 means log CAPEadj 10 (t) and Y (t) are indeed in the same scale. This leads
us to hypothesize heuristically that the ideal scale of log-CAPE is identical to that of Y (t), that is
β1 ≈ 1. The “idealized” log-CAPE decomposition is like

log CAPEadj
10 (t) ≈ const + Y (t) + 20 R (t) − 16 (20% CPI10 (t) + 80% CPI20 (t)) . (3.5)
This mnemonics of relative scale is quite useful since they will show up in many regressions later in
this paper. However, we note that CPI20 (t) is 4 times more significant than CPI10 (t) as indicated
by t-values. It is quite strange that the 20-year inflation has much more influence on 10-year CAPE
than the 10-year inflation. This ratio will change for different types of regression.
We find that, although the exact location and magnitude of each fault line may vary under
different scenarios and optimization methods, the general theme is consistent: One or two major
fault lines are needed before 1929 crash, one of which can go as far back as 1894. One or two
fault lines are needed between 1935 and 1945. This period is very complicated due to the Great
Depression and WWII. Then 1986 is a major fault line affecting the modern decades till now.
The 2009 fault line is found to improve the fit significantly in the past decade. This is obviously
very important to us living in 2018. It is slightly less than 10 years old, thus we are on the verge
of feeling its effect. Whether the financial crisis of 2009 and the subsequent quantitative easyings
cause a major dislocation remains to be seen. Extrapolating this train of thought, the 2017 tax cut
may create yet another large dislocation.
3.4. Remark on Using Y (t) in Real Term

Since the CAPE model operates in the real term, it is reasonable to extend the mean-reversion
framework to Xreal (t) and calculate αreal (T ), Yreal (T ), and Rreal (T ). One may even find this
approach appealing because Yreal (T ) looks more like log-CAPE than Y (T ). However, it can be
easily shown that Yreal (T ) can also be decomposed in the four-factor model:
Yreal (t) ≈ β0 + β1 Y (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) , (3.6)
with a high R2 = 0.90 and β1 ≈ 1. Therefore, Y (t) and Yreal (t) are interchangeable in all the
multi-factor analyses in this paper without adding or losing any information. Our preference is to
separate inflation from Y (t).
15
4. The Periodicity of Mean Reversion and Triangular Waves
We observe that Y (t) is not only mean-reverting, it also manifests periodicity. The period is about
40 years. This is one reason this model is called “jubilee”. In the Old Testimony (Leviticus 25:8-13),
a 50-year cycle was mentioned as the seven times seven years, which involves forgiveness of debt.
In Chinese culture, a 60-year (sexagenary) cycle, called Ganzhi, has been followed since 3000 years
ago. The ancient people seemed to have recognized the existence of economic cycles that last about
half century long.
We explore such periodicity here with about 150 years of financial data we have on hand. We
propose a parsimonious model using triangular waves to study these financial cycles. The slopes of
the triangular waves are directly related to the annualized log-returns, thus conveys clear message
in return analysis.
4.1. The Triangular Wave Model

We first model the channel moving average α
b (t) with two linear segments such as
(
s1 , t ≤ tα ;
b (t) = α0 + s (t − tα ) , s =
α (4.1)
s2 , t > tα ,
where tα = 1939.99, α0 = 8.586, s1 = 0.0713, and s2 = 0.1052. The parameters tα and α0 are
obtained from linear regression while fixing s1 and s2 to the values of the second and third plateaus
of R (T ) (See Figure 2.3).
The channel deviation Yb (t) is modeled by the triangular periodic function Φ (t; p), which has
unit amplitude and period of p,
Yb (t) = Y0 + Y1 Φ (t − tY ; p) ,
(4.2)
2 2πt
where Φ (t; p) = arcsin sin .
π p
It is shown as the blue line in Panel (2) of Figure 4.1. The legs of each cycle are particularly clear.
The total return index is
b (t) = α
X b (t) + Yb (t)
(4.3)
= α0 + Y0 + s (t − tα ) + Y1 Φ (t − tY ; p) ,
shown as the blue line in Panel (1) of Figure 4.1.
4.2. Nominal Returns

Assume s doesn’t depend on t, there are only two values for the slopes of the triangular waves,
b (t)
dX 4Y1
=s± , (4.4)
dt p
which represents the maximum and minimum of log-returns in the model. They are shown as dotted
red lines in Panels (3) and (4) of Figure 4.1 for s = s2 .
16

The nominal returns of period q is rbq (t) = Xb (t) − X
b (t − q) /q. The nominal returns of half
and quarter periods, p/2 and p/4, have simple closed form solutions, assuming s doesn’t change
during the period under consideration:
2b
b t− p 4Y1
rbp/2 (t) = X (t) − X =s+ Φ (t − tY ; p) ,
p 2 p
4b
b t− p 4Y1 h p i
rbp/4 (t) = X (t) − X =s+ Π 2Φ t − tY + ; p ,
p 4 p 8 (4.5)


1, x ≥ 1;
where Π [x] = x, 1 > x > −1;


−1, x ≤ −1.
If p is close to 40 years, then the most natural choices of time interval to study long-term market
returns are 10 and 20 years. This coincides with the convention used by asset allocators, such as
the pension funds and endowments. rb10 (t) and rb20 (t) are shown as blue lines in Panels (3) and (4)
of Figure 4.1.
It is fairly straightforward to determine the periodicity p, but much harder to determine the
amplitude Y1 . We perform nonlinear regression to fit rb10 (t) to empirical data, and obtain Y1 = 0.433
and p = 39.1, with the reference year tY = 1950.76. We then set Y0 = mean (Y (T )), which is 0.0461.
The blue lines in Figure 4.1 are based on this parametrization.
The slopes of X b (t), s ± 4Y1 /p, define the upper and lower bounds of the 10-year and 20-year
nominal returns quite well after WWII. The shape of the 20-year return is similar to the shape of
the triangular wave. More interestingly, the shape of the 10-year return looks like a digit circuitry
that moves up and down between the upper bound and lower bound in four phases. Each phase
is about 10 years. This pattern provides a good mental picture about the 10-year return, which is
otherwise quite illusive (David, Aliaga-Diaz, and Thomas (2012)).
4.3. Forecasting from the Periodicity

The periodicity of the triangular wave carries with it the forecasting power. As of this writing (year
2018), we are nearing the end of the 20-year down cycle in Yb (t) and rb20 (t) that started near year
2000. If the periodicity is true, another great bull market is right around the corner, like 1950’s and
1980’s. This is contrary to the CAPE-based prediction that the lofty P/E ratio will dwarf the stock
market return for many years to come.
The caveat here is that the forecaster has to have considerable faith that the future will repeat
the same pattern as in the past. But this has not been true all the time in the last two centuries. For
instance, between 1900 and 1940, the world went through several financial crises that culminated
in Great Depression and WWII. From the lens of the triangular wave model, the bull market from
1920 to 1929 came 10 years too late and the rise was too strong in the cycle. It caused a violent
downward swing, which was the notorious stock market crash from 1929 to 1933.
We also observe from Panel (4) of Figure 4.1 that the 20-year return didn’t manifest clear cycli-
cality before 1940. The 20-year return was pretty flat, as if the market was trying to manage a
constant return around 7%. Such effort eventually failed due to 1929 crash. The world abandoned
the gold standard and transitioned into an inflationary policy after 1940. After that, the cyclical
pattern became very clear.
17
(1) Channel moving average (2) Channel deviation
1.0
Yb (t) tri.wave
b tri.wave
15
X(t) Y (t) empirical

X(t) empirical
0.5
10
X(t)
Yb (t)
0.0
b
-0.5
tα = 1939.99
5
-1.0
1850 1900 1950 2000 1850 1900 1950 2000
t t
(3) 10-year nominal return (4) 20-year nominal return

0.00 0.05 0.10 0.15 0.20
0.15
0.10
rb10 (t)
rb20 (t)
0.05
tri.wave tri.wave
empirical empirical
1850 1900 1950 2000 1850 1900 1950 2000
t t
Figure 4.1. Triangular wave model. The blue lines are from triangular wave model, and the red lines are empirical.
5. The Tectonic Forecast Model
In this short section, we introduce the general form of the factor-based tectonic forecast model, be-
fore we specialize it to each scenario in the following sections.
Let fk be the factors under consider-
ation: Y (t) , R (t) , CPI10 (t) , CPI20 (t), log CAPE∆Tf (t) . And rf,∆Tf (t) is the forward log-return
of period ∆Tf that we intend to forecast, in nominal term or real term. ∆Tf is either 10 or 20 years.
The simplest mathematical form of the forecast regression is to assume the faults {∆i } are generic,
such that
(
X 0, t < tadj
i ,
∆=
∆i , t ≥ tadj
i ;
i=1···N (5.1)
X
rf,∆Tf (t) ∼ β0 + βk fk (t) + ∆ + ε, for t ∈ [Tstart , Tend ] ,
k=1···5
where ε is the standard error. For a given N , the objective is to minimize the AIC of
the regression by a nonlinear optimization in the parametrization space: {βk , ∀k = 0, 1 · · · 5} ∪
18
n o
tadj
i , ∆ i , ∀i = 1 · · · N .
However, the faults {∆i } in this form is in the unit of the response rf,∆Tf (t). This is saying that
the response is dislocated and needs to be corrected. Our preference is to attribute the dislocations
to one of the major factors, for instance, to log-CAPE, or Y (t). In the case of log-CAPE, we then
prefer to rewrite the regression as
(
X 0, t < tadj
i ;
log CAPEadj (t) = log CAPE∆Tf (t) +
∆Tf
∆i log CAPE∆Tf , t ≥ tadj i .

i=1···N
(5.2)
adj
X
rf,∆Tf (t) ∼ β0 + β1 log CAPE∆T f
(t) + βk fk (t) + ε.
k=2···5

In this form, the faults ∆i log CAPE∆Tf are in the unit of log-CAPE. We feel that this provides
better economic cause-and-effect interpretation. But we acknowledge that the generic representation
Eq. (5.1) is more elegant mathematically, and may conveys a message that we have not thought of
yet as of this writing.
6. Fault Line Adjustment to The CAPE Model
In the second part of this paper, we explore several variations of the equity forecast model. We start
with adjustment to Shiller’s one-factor CAPE model in this section, and evolve into a full fledged
5-factor model that predicts nominal index level in Section 7. We then explore a smaller 4-factor
model by removing the log-CAPE dependency in Section 8.
Multiple variations allow the forecaster to examine the market from different angles. Rarely a
single model can predict the market accurately. Often one must take the average from a group
of models and allow margin of safety in the predictions. (See Chapter 6 and 14 of Elliot and
Timmermann (2016) for further discussion.)
6.1. Weakness of CAPE Model

It has been noted widely that, in the recent past, CAPE model doesn’t work that well in forecasting
10-year real returns of SPX. Siegel (2016) pointed out that the linear regression rfreal
10 (t) ∼ β0 +
β1 log (CAPE10 (t)) + ε over 1881-2004 yields R = 0.35. This is reproduced in Panel (1) of Figure
2
6.1, with β0 = 0.255, β1 = −0.071. The forecasted returns have been much lower than the realized
returns since mid-1980. Worse yet, the model predicts below-average future returns in the next
decade, shown as the red lines in Panels (1) and (3) of Figure 6.1. The future returns are so weak
that SPX would not pass current level in ten years. Many suspects that the lofty CAPE will cause
the economy to stall for years to come.
One obvious issue in the CAPE regression is that |β1 | = 0.071 appears to be too small to
capture the full swing of rfreal
10 (t). Later we will show that |β1 | should be much larger, in the
neighborhood of 0.12. Second, there is a noticeable deviation after 1987. This deviation affects the
forecast throughout 2000, and cast doubt on the future after 2018. This deviation coincides with
our view that there is a large fault line caused by Reagan’s 1986 tax reform. If log (CAPE10 (t)) is
lowered by a certain amount after 1986, the R2 can be increased significantly. Third, the standard
error of regression is very large, ε ≈ 0.04. This leads to Xreal (t)’s two-stdev (95% confidence)
envelope of ±2ε × 10 ≈ ±0.8, shown as purple dotted lines in Panel (3). This error bound in
Xreal (t) is too large to be useful for practical purpose.
Therefore, the CAPE model is in need of a fix. In Siegel (2016), he concluded: “I take no position
on whether the recent changes in accounting conventions are “right” or whether current earnings are
19
too high or too low relative to some “true” value. Accurate evaluation of the CAPE model requires
that the earnings series used observe consistent and uniform conventions across time, ...”. This is
inline with our effort to identify large dislocations in past earnings, in order to make the CAPE
model useful.
6.2. Fault Line Adjustment

We use five fault lines (N = 5) to produce the tectonic CAPE as follows:
(
X 0, t < tadj
i ;
log CAPEadj
10 (t) = log (CAPE10 (t)) + adj
∆ log CAPE , t ≥ t i .
i=1···N i 10 (6.1)

adj
rfreal
10 (t) ∼ β0 + β1 log CAPE10 (t) + ε for t ∈ [Tstart , Tend ] .
The objective
n is to minimize
the AIC of o the regression by a nonlinear optimization on the fault
adj
lines ti , ∆i log CAPE10 , ∀i = 1 · · · N .
Panel (2) of of Figure 6.1 shows one of the best fits, with the fault lines listed in Table 6.1. The
R is 0.819, significantly higher than the 0.34 of the original model. In Panel (4) of Figure 6.1,
2
ε = 0.021 is used to draw the 2-stdev boundary (purple dotted lines) of the log-index prediction
(red line),
h i
[Xreal (t + 10)]pred = Xreal (t) + 10 rfreal
10 (t) ± 20ε. (6.2)
pred
The smaller the standard error is, the more precise the forecast. Realistically speaking, when ε ≈
0.02, the 2-stdev can produce the upper and lower bounds ±0.4 for Xreal (t) that matches the peaks
and bottoms of past bubbles and crashes. The reader can compare Panels (3) and (4) to see the
differences.
The summary of linear regression is shown as:
1 s10 ← lm(eqty.real.logr.f10 ∼ log.cape10.adj, data=df)
2 summary(s10)
1
2 Call:
3 lm(formula = eqty.real.logr.f10 ∼ log.cape10.adj, data = df)
4
5 Residuals:
7 -0.099607 -0.015254 0.002328 0.014684 0.053807
8
9 Coefficients:
11 (Intercept) 0.397628 0.004090 97.23 <2e-16 ***
12 log.cape10.adj -0.118694 0.001431 -82.95 <2e-16 ***
13 ---
14 Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
15
20
(1) 10-year real return forecast, original 1-factor CAPE model

0.05 0.10 0.15 0.20
rfreal
10 (t) R2 = 0.338 β0 = 0.255
regression std err = 0.0396 β1 = -0.071
200y linear reg
10 (t)
rfreal
1987
-0.05
1880 1900 1920 1940 1960 1980 2000 2020
(2) 10-year real return forecast, 1-factor tectonic CAPE model with 5 fault lines
0.05 0.10 0.15 0.20
rfreal
10 (t) R2 = 0.819 β0 = 0.398
regression std err = 0.0207 β1 = -0.119
200y linear reg
10 (t)
rfreal
-0.05
1915.670 1963.920
1907.210 ∆ = -0.451 1944.500 ∆ = 0.583 1985.850
∆ = 0.788 ∆ = -0.503 ∆ = -0.735
1880 1900 1920 1940 1960 1980 2000 2020
(3) Prediction from original CAPE (4) Prediction from tectonic CAPE
12.0 12.5 13.0 13.5 14.0 14.5
12.0 12.5 13.0 13.5 14.0 14.5
Xreal (t) Xreal (t)

prediction prediction
2-stdev 2-stdev
200y linear reg 200y linear reg
Xreal (t)
Xreal (t)
1995 2000 2005 2010 2015 2020 2025 1995 2000 2005 2010 2015 2020 2025
t t
Figure 6.1. Panel (1) The original CAPE model. Panel (2) The tectonic CAPE model with 5 fault lines. Panel (3)
Prediction of Xreal (t) based on the original CAPE model. Panel (4) Prediction of Xreal (t) based on the tectonic
CAPE model.
Notice that |β1 | is now at the 0.12 level. This magnitude is capable of explaining the full swing
in the 10-year return. Naively speaking, |β1 | can be understood as the approximate ratio between
the standard deviations of rfreal
10 (t) and log (CAPE10 (t)), that is, 0.045 and 0.40 respectively.
The fault lines listed in Table 6.1 seem to coincide with major wars and large financial crises and
reforms. How the inflation is accounted for in real return also affects the locations of the fault lines.
There was a big dip in 10-year return at around 1910 that log-CAPE could not capture without 2
21
i tadj
1 1907.21 0.788 This is associated with Panic of 1907, making quality of real
earnings dropped considerably.
2 1915.67 -0.451 This seems to be related to the impact of WWI on the U.S.,
which appears to be positive on future returns.
3 1944.50 -0.503 This adjustment is related to the end of WWII.
4 1963.92 0.583 This adjustment seems related to the U.S. entering Vietnam
war, making quality of real earnings dropped considerably.
5 1985.85 -0.735 This important adjustment is associated with 1986 Tax
Reform Act.
Table 6.1. Five fault lines for 10-year real return forecast in the one-factor model, Eq. ( 6.1).
fault lines. Another big drop near 1964 requires one fault line too.
In Panels (3) and (4), we also draw the 200-year linear regression as sky-blue lines. It was pointed
out in Panel (2) of Figure 2.1 that this line has the strikingly high R2 of 0.994 with 2-stdev of 0.63.
Based on this, the original CAPE model’s prediction is clearly too pessimistic for the most part of
the past two decades. And the forecast based on tectonic CAPE is more inline with the 200-year
linear regression.
7. The 5-Factor Tectonic Forecast Model for Equity Returns
nom (t) denote the nominal forward log-return, and r real (t; ) denotes the real forward log-
Let rf,∆T f f,∆Tf
return, for the look-forward period ∆Tf = 10 or 20. We construct the 5-factor forecast model as
follows:
nominal return :

nom adj
rf,∆Tf
(t) ∼ β 0 + β 1 Y (t) + β 2 R (t) + β 3 CPI 10 (t) + β4 CPI 20 (t) + β 5 log CAPE∆Tf (t) + ε;
real return :

real 0 0 0 0 0 0 adj
rf,∆T f
(t) ∼ β 0 + β 1 Y (t) + β 2 R (t) + β 3 CPI 10 (t) + β4 CPI 20 (t) + β 5 log CAPE ∆Tf (t) + ε0 ;
(7.1)
where t ∈ [Tstart , Tend ] is the in-sample period.n The objective is to minimize the AIC of
o the regression
adj
by a nonlinear optimization on the fault lines ti , ∆i log CAPE∆Tf , ∀i = 1 · · · N . We view our
5-factor model as a meaningful extension of the one-factor CAPE model.
Although the regression can be performed on both real and nominal returns, we find this model
works better for nominal return, because the inflation is accounted for separately from the nominal
return. This is illustrated in Panel (2) of Figure 7.1, in which we only need one fault line before
1920; and no additional fault line is needed between 1945 and 1986.
The nominal return forecast is also advantageous in that it can be translated into index level
prediction without the complication of inflation forecast. The predicted forward returns can be
easily translated to the predictions of log-index Xpred (t) and future SPX level (dividend included)
ppred (t):
h i
nom
Xpred (t + ∆Tf ) = X (t) + rf,∆T f
(t) ∆Tf ± 2ε∆Tf , where t ∈ [Tend − ∆Tf , Tend ] ;
pred
(7.2)
Xpred (t) ±2ε∆Tf
and ppred (t) = e e .
22
i tadj
1 1907.06 1.464 This is likely associated with Panic of 1907. The quality of
earnings deteriorated.
2 1935.61 -1.499 This is likely related to the stimulus package in the
aftermath of Great Depression. It can also be associated
with the Banking Act of 1935, which brought with it many
financial reforms in subsequent years.
3 1944.48 -1.245 This adjustment is associated with the end of WWII. The
U.S. emerged as the world’s super power.
4 1985.85 -0.511 This is the most important adjustment in modern history. It
is obviously associated with 1986 Tax Reform Act.
Table 7.1. The four fault lines for 10-year nominal return forecast in the five-factor model, Eq. ( 7.1).
To estimate forecast error, assume ε ≈ 0.02 for the 10-year forecast, then e20ε ≈ 1.49 and
e−20ε ≈ 0.67. That is, the price forecast can have 33% to 49% of error. This is consistent with our
observation that this forecast model is good for trend line prediction, but not good for predicting
short-term “bubbles and crashes” in the 3-to-5 year timeframe. The reader must be careful in
interpreting the forecast in a proper context. The shorter term forecast has to come from other
type of models and indicators, among which we will supplement the yield curve inversion as an
indicator in Section 7.2.
7.1. 10-Year Nominal Return Forecast

The 10-year model ∆Tf = 10 is certainly most important for asset allocators. We present an
optimized solution with 4 fault lines in Table 7.1 and Figure 7.1. Note that there was no major
dislocation during the forty-year span between 1945 and 1985. This period is the most stable
segment in this model.
It is quite possible that 2008 financial crisis and the ensuring quantitative easing (QE) will create
another fault line, but its true magnitude and how it affect return forecast is yet to be known.
The statistics summary is shown below:
1 c10 ← lm(eqty.logr.f10 ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 + cpi.logr.20 + log.cape10.adj, data=df)
2 summary(c10)
1
2 Call:
3 lm(formula = eqty.logr.f10 ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 +
4 cpi.logr.20 + log.cape10.adj, data = df)
5
6 Residuals:
8 -0.109365 -0.012597 -0.000032 0.013791 0.066178
9
10 Coefficients:
12 (Intercept) 0.4061615 0.0064953 62.532 <2e-16 ***
13 eqty.lm.y -0.0893699 0.0019238 -46.455 <2e-16 ***
14 eqty.lm.r -2.7799165 0.0600485 -46.294 <2e-16 ***
15 cpi.logr.10 -0.0634692 0.0343769 -1.846 0.065 .
16 cpi.logr.20 1.0032385 0.0444895 22.550 <2e-16 ***
17 log.cape10.adj -0.0432981 0.0008149 -53.136 <2e-16 ***
18 ---
19 Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
20
23

The 10-year forecast from the tectonic model is quite positive (red lines in Panels (2), (3), (4)).
SPX will rise to 3000 and stall there around year 2020. Then SPX will continue its upward movement
to 5000 by year 2028. However, the reader must be aware of the purple dotted line envelope for the
95% significance. The range is quite large when bubbles and crashes occur.
On the other hand, the forecast based on original CAPE is slightly pessimistic (but not too
much). This is clearly due to the smaller regression coefficients (Panel (1)) that leads to a dip going
into year 2020 (dotted red lines in Panels (3) and (4)).
Heuristically, we can express the 10-year nominal return as follows:

2 1
rfnom
10 (t) ≈ const − 0.13 Y (t) + log CAPEadj
10 (t) + 20 R (t) + CPI20 (t) . (7.3)
3 3
Inside the bracket, it is one unit of mean reversion plus 20 units of R (t), which is also found in Eq.
(3.5). Also note that CPI10 (t) is marginalized, thus dropped out of the heuristic formula.
7.2. Monte Carlo Simulation and Solution Paths on 10-Year Forecast

It is quite risky for a forecaster to rely on a single solution to forecast the future movement of the
stock market when billions of asset is at stake. We recognize that there are several major fault
lines, and there are many smaller fault lines. The loss function may have many local minimums.
A particular regression may settle on a local minimum, depending on the initial guess. Thus it is
beneficial to perform Monte Carlo simulation and present a group of solution paths and their error
estimates. This will provide a more comprehensive view of the possible future.
Four fault lines are used in the Monte Carlo simulation that forecasts X (t) from rfnom 10 (t). We
initialize the optimizer with simple combinations of 16 equally spaced intervals between 1890 and
2003, from which three fault line locations are drawn, and one fault line is always initialized at year
1986. Total 560 optimizations are performed. The top decile (56) of the solution paths are selected
from those having the lowest AIC scores.
The result is shown in Figure 7.2. The 1996 irrational exuberance is quite obvious. Some solution
paths are able to pick up the 2002 and 2008 crashes. Most of them indicate the current market
is in the middle of the trend, it will peak then slow down as the calendar progress towards 2020.
Whether the slow down will evolve into a severe bear market (30% to 50% drop) will largely depend
on how aggressive the interest rate policy will be.
7.2.1. The Yield Spread Curve. The yield spread curve (GS10-TB3MS, rescaled and shifted)
is shown as the black line in the upper left corner. Yield curve inversion has been found to be one
of the most reliable leading indicators of the past several large-scale bear markets. The trend points
to next inversion around year 2020, but it is totally up to the FED to make it happen or not.
The economic reasoning of yield curve inversion is quite appealing: The stock market can be
viewed as a large financial operation that borrows on short-term rate and lends on long-term rate.
However, companies may engage in excessive leverage to “game the system”, so to speak. Thus,
modulating the yield spread is a key policy tool for FED to tame the excessive speculation. When
the yield spread turns negative, there is no profit to be made, causing dismal earnings for several
quarters, and the market crashes due to lower valuation. Some companies with poor balance sheet
may go into bankruptcy. This effect usually lingers for about 12-24 months.
The narrowing of yield spread also creates a regime switching scenario. In a red hot economy, as
the yield spread becomes smaller, some executives would not think of reducing the balance sheet
24
(1) 10-year nominal forecast, 5-factor model with original CAPE

0.20
rfnom
10 (t)
0.15
regression
0.10
10 (t)
rfnom
0.05
R2 = 0.492
0.00
std err = 0.0338

1987
1880 1900 1920 1940 1960 1980 2000 2020
(2) 10-year nominal forecast, 5-factor tectonic CAPE model with 4 fault lines
0.20
rfnom
10 (t)
regression R2 = 0.813
tri.wave std err = 0.0205
0.15
0.10
10 (t)
rfnom
0.05
0.00
1907.060 1935.610 1944.480 1985.850

∆ = 1.464 ∆ = -1.499 ∆ = -1.245 ∆ = -0.511
1880 1900 1920 1940 1960 1980 2000 2020
(3) Tectonic prediction of log index X(t) (4) Tectonic prediction of SPX level p(t)
5000
empirical
17.0
tectonic prediction
2-stdev empirical
4000
original CAPE prediction

16.5
2-stdev
original CAPE
3000
X(t)
p(t)
16.0
2000
15.5
1000
15.0
2000 2005 2010 2015 2020 2025 2000 2005 2010 2015 2020 2025
t t
Figure 7.1. Forecasting 10-year nominal equity return with 5-factor model.
25
Monte Carlo simulation with 4 fault lines, top decile solution paths
17.5
17.0
16.5
?
16.0
X(t)
15.5
15.0
X(t) empirical
14.5
Xpred (t) solution path

Xpred (t) 2-stdev
yield spread
14.0
1990 2000 2010 2020
Figure 7.2. Five-factor tectonic CAPE model: Monte Carlo simulation on 10-year equity forecast. Top decile (56)
solution paths of Xpred (t) are shown. The yield spread (rescaled) is drawn in black line in the upper left corner, as
an auxiliary indicator that explains the past few bear markets.
risk. Instead, many of them would choose to increase the leverage, in order to generate equal or
more profits to justify the rising stock price. Suddenly, the yield curve is inverted, the mathematics
of leveraging reaches a singularity and the balance sheets of these companies collapse.
7.3. 20-Year Nominal Return Forecast

Since the market has shown the 40-year periodicity, it is natural to come up with the 20-year
forecast, ∆Tf = 20. Only two fault lines are used before WWII:
i tadj
i ∆i log CAPE10
1 1904.96 -0.984
2 1930.73 -1.499
We are impressed that there is no adjustment after 1931. However, we are not able to interpret
what specific historical events are associated with the fault lines. The 1930 fault line is likely related
to the turbulent 1930’s. It seems that twenty years are long enough to smooth out many impacts
in history. Only the largest dislocations remain.
26
The rfnom
20 (t) regression achieves very high R of 0.86. The summary statistics is shown below:
2
1 c20 ← lm(eqty.logr.f20 ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 + cpi.logr.20 + log.cape20.adj, data=df)

2 summary(c20)
1
2 Call:
3 lm(formula = eqty.logr.f20 ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 +
4 cpi.logr.20 + log.cape20.adj, data = df)
5
6 Residuals:
8 -0.041948 -0.007810 -0.000014 0.006608 0.046149
9
10 Coefficients:
12 (Intercept) 0.0942791 0.0021037 44.81 <2e-16 ***
13 eqty.lm.y -0.0240408 0.0011585 -20.75 <2e-16 ***
14 eqty.lm.r 0.4133839 0.0257273 16.07 <2e-16 ***
15 cpi.logr.10 0.3746269 0.0168975 22.17 <2e-16 ***
16 cpi.logr.20 -0.9290867 0.0273386 -33.98 <2e-16 ***
17 log.cape20.adj -0.0246666 0.0004043 -61.02 <2e-16 ***
18 ---
19 Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
20
Heuristically, we can express the 20-year nominal return as follows:

11 1 1
rfnom
20 (t) ≈ const − Y (t) + log CAPEadj 10 (t) − 8 R (t) + CPI10 (t) − CPI20 (t) .
20
2 2 3
(7.4)
Note that the signs in front of R (t) and CPI20 (t) are the opposite of those in Eq. (7.3).
The result is shown in Figure 7.3. The 20-year tectonic CAPE model (red line of Panel (2))
predicts a bright future for the next 10 years (red line of Panel (3)). It is clearly not the case if we
use the original CAPE in the 5-factor model, which is the red line of Panel (1). It predicts X (t)
nearing the bottom of 2-stdev boundary (dotted red line of Panel (3)). However, we note that even
a small error in the 20-year return forecast can cause a large difference in the price level forecast.
The positive outlook coincides with the 40-year triangular cycle that the market is on the verge
of entering another great bull market after 2020. Only the future will tell if it is right or wrong.
8. Possibility of Moving Beyond CAPE
In Section 3, it was shown that Y (t) and 10-year log-CAPE are very similar. In this section, we
explore a four-factor forecast model without log-CAPE. That is, no valuation metrics are directly
involved in the forecast regression.
To construct the “tectonic channel deviation” Y adj (t), we add the fault lines to Y (t) such that
(
X 0, t < tadj
adj i ,
Y (t) = Y (t) + adj (8.1)
i=1···N
∆Y i , t ≥ t i .
27
(1) 20-year nominal forecast, 5-factor model with original CAPE
R2 = 0.495
0.15
rfnom
20 (t) std err = 0.0210
regression
tri.wave
0.10
20 (t)
rfnom
0.05
0.00
1880 1900 1920 1940 1960 1980 2000 2020
(2) 20-year nominal forecast, 5-factor tectonic CAPE model with 2 fault lines
R2 = 0.867
0.15
rfnom
20 (t) std err = 0.0108
regression
tri.wave
0.10
20 (t)
rfnom
0.05
1904.960 1930.730
∆ = -0.984 ∆ = -1.499
0.00
1880 1900 1920 1940 1960 1980 2000 2020
(3) Tectonic prediction of log index X(t) (4) Tectonic prediction of SPX level p(t)
19
10000
empirical
18
tectonic prediction
2-stdev empirical
8000
original CAPE tectonic prediction

2-stdev
17
original CAPE
X(t)
6000
p(t)
16
4000
15
2000
14
1990 2000 2010 2020 2030 2000 2005 2010 2015 2020 2025
t t
Figure 7.3. Forecasting 20-year nominal equity returns with the 5-factor tectonic CAPE model. Only two fault lines
before WWII are needed to correct the dislocations.
28
i tadj
i ∆Yi
1 1903.66 0.524
2 1935.37 -0.527
3 1944.57 -0.467
4 1986.79 -0.392
5 1992.23 0.436
Table 8.1. The five fault lines of 10-year nominal return forecast in the four-factor tectonic Y (t) model, Eq. ( 8.2).
The 10-year forecast model is the following linear regression:
rfnom
10 (t) ∼ β0 + β1 Y
adj
(t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) + ε. (8.2)
The
n objective is to minimizeo the AIC of the regression by nonlinear optimization on the fault lines
adj
ti , ∆Yi , ∀i = 1 · · · N . Even without any fault line adjustment (N = 0), the R2 of Eq. (8.2) is
0.46, already much higher than the 0.34 of the original CAPE model and the 0.40 of Siegel (2016).
We use five fault lines to optimize the regression. The optimizer can locate very good fits. We
show one such solution that contains 1986 fault line with the best AIC in Panel (1) of Figure 8.2.
The fit has very good R2 of 0.85 and ε = 0.0183. The fault lines are listed in Table 8.1. Their
locations are nearly the same as those in Panel (2) of Figure 7.1, except 1992 is added as the fifth.
The summary statistics is show below:
1 y10 ← lm(eqty.logr.f10 ∼ eqty.lm.y.adj + eqty.lm.r + cpi.logr.10 + cpi.logr.20 , data=df)
2 summary(y10)
1
2 Call:
3 lm(formula = eqty.logr.f10 ∼ eqty.lm.y.adj + eqty.lm.r + cpi.logr.10 +
5
6 Residuals:
8 -0.106809 -0.010760 0.000412 0.012648 0.074121
9
10 Coefficients:
12 (Intercept) 0.327124 0.004412 74.147 <2e-16 ***
13 eqty.lm.y.adj -0.116974 0.001580 -74.053 <2e-16 ***
14 eqty.lm.r -3.264798 0.056098 -58.198 <2e-16 ***
15 cpi.logr.10 0.236962 0.028295 8.375 <2e-16 ***
16 cpi.logr.20 1.050342 0.039153 26.827 <2e-16 ***
17 ---
18 Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
19
To explore the model variation, Monte Carlo simulations (cf. Section 7.2) are performed, and the
top decile of solution paths are drawn in Panel (2) of Figure 8.2. The result is very similar to Figure
7.2.
This 4-factor tectonic Y (t) model can be easily applied to rfnom20 (t). A good fit with R of 0.84
2
can be achieved by a major fault line at 1930.21 with ∆Y = −1.023. We won’t repeat the regression
here.
29
(1) 10-year nominal forecast, 4-factor tectonic Y (t) model with 5 fault lines
0.20
rfnom
10 (t)
regression R2 = 0.850
std err = 0.0183
0.15
tri.wave
0.10
10 (t)
rfnom
0.05
1935.370 1986.790
0.00
∆ = -0.527 ∆ = -0.392
1903.660 1944.570 1992.230
∆ = 0.524 ∆ = -0.467 ∆ = 0.436
1880 1900 1920 1940 1960 1980 2000 2020
(2) Tectonic Y (t) model with 5 fault lines: Top decile solution paths
17.5
17.0
16.5
?
16.0
X(t)
15.5
15.0
X(t) empirical
Xpred (t) solution path
14.5
Xpred (t) 2-stdev

yield spread
14.0
1990 2000 2010 2020
Table 8.2. Ten-year nominal return forecast made by the 4-factor tectonic Y (t) model. No valuation metrics are
directly involved. The result is as good as the 5-factor tectonic CAPE model.
9. Equity Cycle Leads Treasury Cycle
In this section, we propose a forecast model for the 10-year Treasury yield (GS10), built on the same
components as in the equity model. The interest rate process has been known to be mean-reverting,
since it is bounded by a range. Whether it follows periodicity is less obvious. GS10 has exhibited a
long-term cycle since 1940’s, as shown in Panel (1) of Figure 9.1. In 1941, the yield reached a low
30
at 1.95%; and then in 1981, the yield climbed to an all-time high of 15.3%. Again in 2016, the yield
reached another low of 1.5%. This is 75 years later. Such GS10 cycle is explored.
We must note that this model is highly experimental. The GS10 cycle is twice longer than the
equity cycle. And the GS10 cycle prior to 1930 is quite different, which was likely associated to the
change of the gold standard, and the inflation management policy by the central banks thereafter.
Our major finding is that the equity cycle drives and leads the interest rate cycle. In Section 10,
we will show that the equity cycle also drives and leads the gold cycle. Therefore, the equity market
plays a central role in modern financial market.
9.1. Mean Reversion Over Optimal Yield

We first introduce the concept of the optimal yield Iopt , which is 4.6%, determined later by the
regression. When the GS10 yield moves towards such level, it coincides with periods of high equity
returns. On the contrary, when the GS10 yield moves away from such level, it coincides with periods
of low equity returns. And the equity cycle leads the GS10 cycle by approximately 6 years. We prove
such hypothesis as follows.
The mean-reverting variable of GS10 is defined as
G (t; Iopt ) ≡ |log GS10 (t) − log Iopt | (9.1)
One-Factor Model. We assume Y (t) leads G (t), and we determine the lead time k and optimal
yield Iopt between Y (t) and G (t) by minimizing the AIC of the following regression:
G (t + k; Iopt ) ∼ Y (t) , t ∈ [1940, 2017] . (9.2)
All the values of k from 12 months to 80 months, and Iopt between 3% and 8% are tested. The
optimal values of k and Iopt are 74 months and Iopt = 4.6%1 . Coincidentally, 4.6% is also the
long-term average of GS10 yield hGS10 (t)i from 1871 to 2017. This mid-point interest rate seems
to have a significant role in the financial market.
Once k and Iopt are determined, we perform regression on both the one-factor and four-factor
models. The smaller model is simpler and more intuitive, while the larger model can produce better
fit. The one-factor model is

74
G t + ; Iopt = 4.6% ∼ β0 + β1 Y (t) + ε, t ∈ [1940, 2017] . (9.3)
12
We obtain β0 = 0.50, β1 = −0.65, with R2 = 0.72 and standard error of 0.15. It is impressive that
a single factor regression has such a high R2 .
Four-Factor Model. We then regress the four-factor model :

74
G t + ; Iopt = 4.6% ∼ β0 + β1 Y (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) + ε, t ∈ [1940, 2017] ;
12
(9.4)
and obtain R = 0.78 with standard error of 0.13. (Log-CAPE is statistically insignificant, therefore,
2
is not included in the model.) The results are shown in Panel (2) of Figure 9.1. The one-factor
1 We also test the causality by the Granger test, which gives 38 months of lead time, but the regression optimization shows the
lead time is much longer.
31
result is the red line and the four-factor result is the purple line. The two overlap most of the time,
indicating Y (t) is dominant factor here.
We note that heuristically from the result of Eq. (9.3), G (t + k) is about one-half of 1 − Y (t).
If this relation is indeed true for the foreseeable future, the direction of Y (t) can predict the GS10
movement 6 years ahead of time.
9.2. Forecasting GS10 Yield

By further exploiting the cyclicality of G (t), we can transform Eq. (9.3) into a forecast model for
longer horizon. Define the 20-year forward return of G (t) as
1
rfG20 (t) ≡ (G (t + 20) − G (t)) (9.5)
20
We perform the one-factor regression as follows,
rfG20 (t + k) ∼ β 0 + β 1 Y (t) + ε, where t ∈ [1940, 2017] ; (9.6)
and obtain β 0 = −0.0052, β 1 = 0.0652, and R2 = 0.78. The high R2 confirms our conviction that
Y (t) is the major predictor in the forecast model.
The larger 4-factor model produces even higher R2 of 0.90 (Log-CAPE is statistically insignificant,
therefore, is not included in the model):
rfG20 (t + k) ∼ β 0 + β 1 Y (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) + ε, where t ∈ [1940, 2017] .
(9.7)
The summary statistics is shown below:
1 g.logr ← lm(rate.G.logr.f20.lag ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 + cpi.logr.20 , data=df)
2 summary(g.logr)
1
2 Call:
3 lm(formula = rate.G.logr.f20.lag ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 +
5
6 Residuals:
8 -0.0186838 -0.0061777 -0.0007345 0.0053805 0.0243510
9
10 Coefficients:
12 (Intercept) 0.056884 0.003627 15.68 <2e-16 ***
13 eqty.lm.y 0.040008 0.001674 23.90 <2e-16 ***
14 eqty.lm.r -0.849824 0.042146 -20.16 <2e-16 ***
15 cpi.logr.10 -0.377580 0.030793 -12.26 <2e-16 ***
16 cpi.logr.20 1.027545 0.044429 23.13 <2e-16 ***
17 ---
18 Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
19
32
(1) 10-year Treasury cycle (GS10) and prediction

2.5
log GS10(t)
1-factor prediction
4-factor prediction
2.0
log GS10(t)
2030
log(4.6)
1.5
log(3.0)
1.0
log(2.0)
0.5
1940 1960 1980 2000 2020
(2) Causality between Treasury’s G(t) and equity’s Y (t) (74 months lag)
1.2
G(t)
Y (t) regression Optimal causality = 74 months
4-factor regression
1.0
tri.wave
Optimal rate = 4.6 pct
0.8
G(t)
0.6
0.4
1-factor R2 = 0.718 4-factor R2 = 0.778

0.2
std err = 0.1503 std err = 0.1337

0.0
1940 1960 1980 2000 2020
(3) Prediction of 20-year return of G(t) (74 months lag)
rfG20 (t) 1-factor R2 = 0.782 4-factor R2 = 0.899

0.04
Y (t) regression std err = 0.0122 std err = 0.0083

4-factor regression
tri.wave
0.02
rfG20 (t)
0.00
-0.02
-0.04
-0.06
1940 1960 1980 2000 2020
Figure 9.1. Panel (1) 10-year Treasury yield since 1940. Prediction from the 20-year return of G (t): red lines are
from the one-factor model, and purple dotted lines are from the 4-factor model. Panel (2) Causality and regression
of G (t). Panel (3) The forecast model for the 20-year return of G (t).
33
The GS10 yield can then be predicted by

Gpred (t + 20) = G (t) + 20 rfG20 (t) pred ± 40ε,
(
Iopt exp (−Gpred (t) ± 40ε) , when GS10pred (t) < Iopt ; (9.8)
and GS10pred (t) =
Iopt exp (Gpred (t) ± 40ε) , when GS10pred (t) ≥ Iopt .
Note that there is an uncertainty far into the future whether Gpred (t) should be unfolded to
GS10pred (t) using plus or minus sign in the exponential. In our simulation, we assume the mi-
nus sign for the foreseeable future.
The regression of rfG20 (t) is shown in Panel (3) of Figure 9.1. And the log-GS10 (t) prediction
for the next 15 years is shown on the right side of Panel (1) in Figure 9.1. Red lines are from the
one-factor model. Purple dotted lines are from the 4-factor model. As we can see, although the
yield may spike up in 2018-2019, it will be kept at 2-3% level several years after 2020 to finish up
the cycle. Then it goes up to Iopt in 2030.
10. Equity Cycle Leads Real Gold Price Cycle
real (t) be the log price of gold subtracted by the log of CPI. We observe
Let gold’s real (log) price Xgold
real (t) went through similar 40-year cycles, shown as the blue line in Panel (1) of Figure
that Xgold
10.1. Thus it is another important mean-reverting process in the financial market. However, the
history of gold price is less than 90 years (since 1932). This is much shorter than the history of the
U.S. stock market (more than 200 years since 1801).
Due to the smaller sample size and large volatility, the forecast model is highly experimental. It is
presented here as an intellectual curiosity because of its high correlation with Y (t). In the long term,
gold has almost no real gain. Its investment value is cyclical. And its price can get very volatile at
times. The investors must verify the stability and precision of the forecast model carefully.
10.1. One-Factor Model

The periodicity of Xgold
real (t) coincides with that of the equity market. That is, Y (t) and X real (t)
gold
are highly correlated, and the former leads the later by about 30 months. This is evident in the
one-factor model:
real
Xgold (t + k) ∼ β0 + β1 Y (t) + ε, t ∈ [1930, 2017] , (10.1)
where k = 30/12, β0 = 0.87, β1 = −1.04, and R2 = 0.55 with ε = 0.35. This regression is shown as
the red line in Panel (1) of Figure 10.1.
Since β0 ≈ 1 and β1 ≈ −1, we hypothesize heuristically that Xgold real (t + k) ≈ 1 − Y (t) once its

small net real gain is detrended. Previously, we’ve also shown that log CAPEadj 10 (t) ≈ const+Y (t)
in Section 3.3, and G (t + k) ≈ 21 − 21 Y (t) in Section 9.1. Thus we find strong evidences that Y (t)
defines the universal scale of mean reversion for these three major asset classes.
The reason that the starting date is set to 1930, but not older, is because 1930 was the onset
of the gold’s price movement. Before 1932, dollar was pegged to gold at about $20 per ounce via
international gold standard. Gold didn’t have “price” of its own. The first price movement of gold
occurred at 1933 when the U.S. repriced gold abruptly from $20.67 to $35.
34
10.2. Five-Factor Model

Next, we replicate the five-factor model for Xgold
real (t). We perform the following linear regression:
real
Xgold (t + k) ∼ β0 + β1 Y (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) + β5 log (CAPE10 (t)) + ε,
(10.2)
for t ∈ [1930, 2017], which results in high R2 of 0.80. All five factors are highly significant. This
regression is shown as the red line in Panel (2) of Figure 10.1. The summary statistics is shown
below:
1 gld ← lm(gold.real.logp.lag ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 + cpi.logr.20 + log.cape10, data=df)
2 summary(gld)
1
2 Call:
3 lm(formula = gold.real.logp.lag ∼ eqty.lm.y + eqty.lm.r + cpi.logr.10 +
4 cpi.logr.20 + log.cape10, data = df)
5
6 Residuals:
8 -0.64624 -0.15066 -0.01864 0.16614 0.83509
9
10 Coefficients:
12 (Intercept) -0.94854 0.06827 -13.893 <2e-16 ***
13 eqty.lm.y -1.94023 0.04512 -43.003 <2e-16 ***
14 eqty.lm.r -17.71028 1.27096 -13.935 <2e-16 ***
15 cpi.logr.10 4.66629 0.47682 9.786 <2e-16 ***
16 cpi.logr.20 15.12908 0.76406 19.801 <2e-16 ***
17 log.cape10 1.04094 0.04407 23.621 <2e-16 ***
18 ---
19 Signif. codes: 0 ’***’ 0.001 ’**’ 0.01 ’*’ 0.05 ’.’ 0.1 ’ ’ 1
20
24 F-statistic: 792.9 on 5 and 1022 DF, p-value: < 2.2e-16
Gold is positively correlated to inflation, and negatively correlated to the stock market. This
matches our intuition. The 30-month lag in the regression makes it possible to forecast gold’s
movement more than 2 years in advance.
Gold’s high negative correlation to the stock market has an implication to long-term investors.
During a 40-year cycle, gold can rise sharply in a decade-long rally when the stock market stalls,
as witnessed from 2001 to 2011. On the other hand, when the stock market is in its up cycle, gold
simply moves sideway with a lot of volatilities, e.g. from 1981 to 2000. Since gold doesn’t have real
long-term gain, it is important to understand such cyclicality, if precious metal is an option in the
asset allocation roadmap.
In the current cycle, it is highly possible that the stock market has bottomed in 2009, and gold
reached its peak in 2011. If this is true, then gold may have entered into the down cycle with many
years of sideway movement ahead. The only chance that gold may have another big rally in the near
future is when Y (t) drops significantly in 2020. But still it seems unlikely that gold can challenge
its 2011 peak.
10.3. 20-Year Forecast

For longer horizon, we can build a 20-year return forecast model such as
REFERENCES 35
rfreal
20 (t + k) ∼ β0 + β1 Y (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) + β5 log (CAPE10 (t)) + ε.
(10.3)
It is regressed between 1933 and 2018 with R2 = 0.68. (Although log-CAPE is included here, it
has the lowest confidence level among all factors.) The result is shown in Panel (3) of Figure 10.1.
We are less certain about the stability of this forecast model since the data period is rather short
and the regression is quite sensitive to the choice of the starting year. We present the model here
for the sake of completeness, so that we can track it and improve it as more data become available
in future years.
11. Acknowledgement
I thank Professor John Mulvey for his guidance and discussions that lead to this work. Finally, I’d
like to thank my family members that this work can’t be accomplished without their tolerance. I
am very grateful for them.
References
Campbell, John Y., and Robert J. Shiller (1988). Stock Prices, Earnings, and Expected Dividends. Journal
of Finance, Vol. 43, No. 3, pp. 661-676.
Campbell, John Y., and Robert J. Shiller. (1998). Valuation Ratios and the Long-Run Stock Market Outlook.
Journal of Portfolio Management, Vol. 24, No. 2, pp. 11-26.
Cox, J.C., J.E. Ingersoll and S.A. Ross (1985). A Theory of the Term Structure of Interest Rates. Econo-
metrica. 53: 385–407. doi:10.2307/1911242
Davis, J., Aliaga-Díaz, R., and Thomas, C. J. (2012). Forecasting stock returns: What signals matter, and
what do they say now. Vanguard Research.
Elliot, Graham, and Timmermann, Allan (2016). Economic Forecasting. Princeton University Press. ISBN:
978-0-691-14013-1.
Fan, Jianqing, and Yao, Qiwei (2017). The Elements of Financial Econometrics. Cambridge University Press.
ISBN: 978-1-107-19117-4.
FRED (2018). Economic Data at Federal Reserve Bank of St. Louis. https://fred.stlouisfed.org/
Lihn, Stephen H.-T. (2017). From Volatility Smile to Risk Neutral Probability and Closed Form Solution of
Local Volatility Function. SSRN: 2906522.
Lihn, Stephen H.-T. (2017). A Theory of Asset Return and Volatility Under Stable Law and Stable Lambda
Distribution. SSRN: 3046732.
Lihn, Stephen H.-T. (2018). Laplace-Based Multivariate Process and Joint Modeling of SPX and VIX. Tech-
nical report, unpublished.
Minneapolis FED (2018). Consumer Price Index Since 1800. https://www.minneapolisfed.org/community/financial-
and-economic-education/cpi-calculator-information/consumer-price-index-1800
John M. Mulvey, Han Hao, and Nongchao Li (2017). Machine Learning, Economic Regimes and Portfolio
Optimization. Princeton ORFE Working Paper.
Schwert, G. W. (1989). Indexes of United States Stock Prices From 1802 to 1987. NBER Working Paper
No. 2985.
Siegel, Jeremy J. (2014). Stocks for the long run. McGraw-Hill. ISBN: 0-07-180051-4.
Siegel, Jeremy J. (2016). The Shiller CAPE Ratio: A New Look. Financial Analysts Journal, Vol 72, No. 3.
Robert J. Shiller (2014). The Mystery of Lofty Stock Market Elevations. New York Times.
https://www.nytimes.com/2014/08/17/upshot/the-mystery-of-lofty-elevations.html
Robert J. Shiller (2018). Online Data for U.S. Stock Markets 1871-Present and CAPE Ratio.
http://www.econ.yale.edu/~shiller/data.htm
Robert J. Shiller (2018). The World’s Priciest Stock Market. Project Syndicate. https://www.project-
syndicate.org/commentary/us-stock-market-highest-cape-ratio-by-robert-j--shiller-2018-01
36 REFERENCES
(1) Gold real log-price vs equity’s 1 − Y (t) (30 months lag)
real (t)
2.0
Xgold
Y (t) regression R2 = 0.547 β0 = 0.869
1 − Yb (t) tri.wave std err = 0.3499 β1 = -1.035
1.5
real (t)
1.0
Xgold
0.5
0.0
1850 1900 1950 2000
t (year)
(2) Five-factor regression of gold real log-price (30 months lag)

2.0
real (t)
Xgold R2 = 0.795
regression std err = 0.2357
1.5
real (t)
Xgold
1.0
0.5
0.0
1850 1900 1950 2000
t (year)
(3) Five-factor regression of gold’s 20-year real return (30 months lag)
0.10
R2 = 0.677
rfreal
20 (t) std err = 0.0225
regression
0.05
20 (t)
rfreal
0.00
-0.05
1850 1900 1950 2000
t (year)
real
Figure 10.1. Panel (1) Comparison between gold’s real log-price Xgold (t) and Y (t). Panel (2): Regression result of
real
the 5-factor model, Eq. (10.2), on Xgold (t) . Panel (3) Regression result of the 5-factor model, Eq. (10.3), on gold’s
20-year real return rfreal
20 (t).

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April 4, 2018 Quantitative Finance jubilee

To appear in ..., Vol. 00, No. 00, Month 20XX, 1–35

Jubilee Tectonic Model: Forecasting Long-Term Growth

Stephen H.-T. Lihn†

(v1.0, Released on April 4, 2018)

JEL Classification: C38; C53; E32; E37; E47

thor. Email: stevelihn@gmail.com; LinkedIn: https://www.linkedin.com/pub/stephen-horng-twu-lihn/0/71a/65. Stephen Lihn

Electronic copy available at: https://ssrn.com/abstract=3156574

∆X (t) = η (νbear − σ (t)) ∆t + η 0 σ (t) ε1 +? (X (t) − [long term trend])?,

Electronic copy available at: https://ssrn.com/abstract=3156574

sgn (X (t) − µ) σL2

1.2. Main Results and Organization of The Paper

1.3. Source of Data

2. Mean-Reversion of The U.S. Stock Market

2.1. Total Return Index

2.2. Mean-Reversion Decomposition

X (t) ∼ α (T ) + R (T ) (t − T ) , where t ∈ [T − ∆Tb , T ] , (2.2)

(1) Nominal logarithmic total return index of SPX

1800 1850 1900 1950 2000

(2) Real logarithmic total return index of SPX

Slope = 0.0655 (real equity premium)

1800 1850 1900 1950 2000

2.3. Closed Form Solution

2.4. Optimal Choice of Look-back Channel at 45 Years

1 See also https://cran.r-project.org/web/packages/genlasso/vignettes/article.pdf

3. Relation to CAPE and CPI

3.1. Decomposition of log-CAPE

log CPI (t) − log CPI (t − ∆T )

(1) Channel moving average

1800 1850 1900 1950 2000

(2) Channel deviation

1800 1850 1900 1950 2000

(3) Channel return

1800 1850 1900 1950 2000

11 Estimate Std. Error t value Pr(>|t|)

3.2. Lofty CAPE?

3.3. Tectonic CAPE

(1) log(CAP E 10 (t)) (centered) vs Y (t)

1800 1850 1900 1950 2000

(2) R(t) and CPI log-returns CP I 10 (t) and CP I 20 (t)

1800 1850 1900 1950 2000

(3) Four-factor regression of log(CAP E 10 (t))

log(CAP E 10 (t)) std err = 0.1904

1800 1850 1900 1950 2000

(4) Four-factor regression of tectonic CAPE with 4 fault lines

1894.380 1937.780 1986.420 2009.260

1800 1850 1900 1950 2000

11 Estimate Std. Error t value Pr(>|t|)

3.4. Remark on Using Y (t) in Real Term

Yreal (t) ≈ β0 + β1 Y (t) + β2 R (t) + β3 CPI10 (t) + β4 CPI20 (t) , (3.6)

4. The Periodicity of Mean Reversion and Triangular Waves

4.1. The Triangular Wave Model

shown as the blue line in Panel (1) of Figure 4.1.

4.2. Nominal Returns

4.3. Forecasting from the Periodicity

(1) Channel moving average (2) Channel deviation

X(t) Y (t) empirical

(3) 10-year nominal return (4) 20-year nominal return

1850 1900 1950 2000 1850 1900 1950 2000

5. The Tectonic Forecast Model

6. Fault Line Adjustment to The CAPE Model

6.1. Weakness of CAPE Model

6.2. Fault Line Adjustment