The cyclically-adjusted price-to-earnings (CAPE) ratio of a stock market is one of the standard metrics used to evaluate whether a market is overvalued, undervalued, or fairly-valued.
This metric was developed by Robert Shiller and popularized during the Dotcom Bubble when he argued (correctly) that equities were highly overvalued. For that reason, it’s also casually referred to as the “Shiller PE”, meaning the Shiller variant of the typical price-to-earnings (P/E) ratio of stock.
It’s most commonly applied to the S&P 500, but can be and is applied to any stock index. The main benefit is that it helps you determine how much of your portfolio should reasonably be invested into equities based on the current relationship between the price you pay for them and the value you get in return in the form of earnings.
When the CAPE ratio is high, it’s usually wise to reduce your equity exposure.
Updated CAPE Ratio Chart
This is a chart that I update regularly based on raw data from Shiller’s website.
How the CAPE Ratio Works
For any investment, price is what you pay, and value is what you get.
Therefore, there are a variety of metrics that compare price to value. The most commonly-used one is called the Price-to-Earnings (P/E) ratio, which divides the price of a share of stock by the annual earnings per share of that stock. Normally, you want to buy a healthy and growing company when its shares are trading at a low P/E ratio, so you get plenty of earnings for the price you pay.
This can be applied to an index as well, so for example, you can take the aggregate price of the shares of companies that make up the S&P 500 and divide that figure by their aggregate corporate earnings that year, and arrive at an average P/E for the index.
Here’s the problem. During a recession, stocks fall, but corporate earnings fall sharply as well, which can temporarily raise the P/E ratio. Since we want to buy when the P/E is low, this gives us a false signal that the market is expensive, that we shouldn’t buy, when indeed it’s the best time to buy.
Robert Shiller, a professor of economics at Yale and a Nobel laureate, popularized a specific version of the cyclically-adjusted price-to-earnings ratio to help smooth this out and show a more accurate representation of the ratio between current price and earnings.
The way it works, is you take the average of the last ten years of earnings, adjust them for inflation, and divide the current index price by that adjusted earnings. This makes it so that the current price is divided by the average earnings over the latest business cycle rather than just one year of bad or good earnings.
Why the CAPE Ratio is Important
Robert Shiller demonstrated using 130 years of backtested data that the returns of the S&P 500 over the next 20 years are strongly inversely correlated with the CAPE ratio at any given time.
In other words, whenever the CAPE ratio of the market is high, it means stocks are overvalued, and returns over the next 20 years will likely be poor. In contrast, whenever the ratio is low, it means the stocks are undervalued, and returns over the next 20 years will likely be good.
This is intuitive. When stocks are cheap, they can increase in price both from increasing corporate earnings and from an increasing price-to-earnings ratio on that figure. But when stocks are already expensive, and already have a high price-to-earnings ratio, they have a lot less room to grow and a lot more room to fall the next time there’s a recession or market correction.
Since that time, more research groups have analyzed the relationship between CAPE and long-term returns on a broader scale.
Here, for example, is their chart of the CAPE ratio along with S&P 500 growth:
As can be seen, during periods where the CAPE ratio of the S&P 500 became rather high, returns over the next decade and more were invariably rather poor.
When you graph the CAPE on one axis and inflation-adjusted returns on the other axis, you get a pretty strong inverse correlation. A higher CAPE starts decreasing the odds that returns will be decent over the next 15 years:
The only countries that managed to violate it pretty consistently were Sweden and Denmark, which gave great returns despite a very high CAPE:
As the 2016 research study pointed out, though, the markets of Sweden and Denmark underwent major structural changes during that time. Denmark had nearly double the earnings growth as the US had, their number of index companies decreased from 20 t0 11, and the healthcare sector went from 10% of the index to 60% of the index.
That shows us that in extreme situations involving small markets with just a handful of companies with major structural changes, the CAPE can be misleading.
In just about any other context, it’s very reliable.
Limitations of the CAPE Ratio
In recent years, many people have questioned whether the metric is still a viable way to measure market valuation.
For example, some people have argued that changes in accounting rules have altered how we define corporate earnings, which can skew the current CAPE ratio measurement compared to how it was measured in the past.
For this reason, I like to use a second metric, called the Cap/GDP ratio.
This metric was popularized by Warren Buffett nearly 20 years ago. The way it works, is you divide the total market capitalization (approximated by the Wilshire 5000 index) by the gross domestic product.
This is another way to measure price against value. The market capitalization is the price that investors in aggregate are paying for all shares of all public companies. The GDP is the actual economic output of the country.
If share price starts to outpace real economic output, then we may have an overvalued market on our hands.
Here’s the current chart:
As you’ll notice, the CAPE ratio and the Cap/GDP ratio correlate very closely, which further strengthens the case that the CAPE ratio is a reliable measure of market valuation.
Shortcomings of CAPE and Cap/GDP
- The CAPE ratio can potentially be skewed if accounting rules change enough over time. Without adjusting for those changes, it can become misleading to compare one period to another. So far, this has not been a massive effect, but there have been various proposals for adjustments that can affect the outcome modestly.
- The CAPE ratio can be misleading if you apply it to a tiny index undergoing structural changes. For example, tech companies generally have fast growth and command higher valuations than tobacco companies. If an index were to shift primarily from tobacco to technology (an extreme example), its valuation would justifiably increase considerably. This is essentially what occurred in Denmark, except for healthcare.
- If corporations get a larger and larger percentage of their profits from oversees, then the Capitalization/GDP ratio becomes less relevant. Companies can keep increasing in value at a rate that exceeds their own country’s GDP growth by selling a greater and greater share of their products and services abroad. Or vice versa.
- GDP measures economic output of publicly traded companies and private businesses, while the market capitalization is purely representative of the value of publicly traded companies. If a percentage of the economy shifts from private businesses to publicly-traded ones, then the nation’s total market capitalization would rise even if GDP growth stays flat. Or, again, vice versa.
Neither of these two ratios are perfect, but both of them are useful, which is why I always look at them together. They smooth out each other’s flaws.
I pay attention to CAPE and Cap/GDP closely, because it helps inform my investment decisions.
I also regularly analyze the cash flows of companies on the market to determine their fair price and to see how many companies are trading above what their cash flows imply they should be trading at.
These posts go into a lot of detail about how I employ the use of valuation metrics:
- Risk vs Volatility: How to Profit from the Difference
- Contrarian Investing 101: What it is and Why it Outperforms
Long story short, when markets are cheap, I increase my exposure to equities and leave myself with a lot of upside potential. When markets are expensive, I back away from equities a bit (but not entirely), shift some money to alternative assets, and sell cash-secured put options on equities to keep my cost basis lower and get paid to wait for a dip.