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 is one of several broad valuation metrics that can help 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, and other valuation methods are high, it’s usually not a bad idea to trim your equity exposure or invest elsewhere where markets are cheaper.
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 that 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 recent year of bad or good earnings.
Why the CAPE Ratio is Important
Robert Shiller demonstrated using 130 years of back-tested 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.
Star Capital in particular released an excellent set of research papers in March 2014 and again in January 2016 that analyzed this question from a global perspective.
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.
Meb Faber, the CFO of Cambria Investment management, calculated that if you had invested in the cheapest 25% of countries in terms of CAPE, you would have crushed the S&P 500 between 1993 and 2018 (orange line vs dark blue line):
Chart Source: Meb Faber
That chart is logarithmic so the visual difference is smaller than it really is. Investing in the S&P 500 would have returned 962% from 1993 to 2018. Investing in the cheapest 25% of countries based on CAPE ratios would have returned 3,052%, or more than three times as much.
Faber initial calculated that back in 2016 (and updated it in 2019), and chose to do so because many opponents of the CAPE ratio’s usefulness have pointed out that the United States has had historically elevated cape ratios since the 1990’s and yet still produced decent returns, which calls into question the usefulness of the CAPE ratio.
Faber pointed out with this research how it’s relative. Sure, the U.S. stock market still produced decent returns even with elevated CAPE ratios, but if you had invested in the cheapest countries based on CAPE you would have done far, far better.
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.
And as I described above, some people have pointed out that CAPE ratio has been relatively high in the U.S. since the 1990’s but the stock market still produced solid returns. Faber’s research shows the limitations of that argument.
But still, I like to use more than one broad valuation metric. In particular, the market-capitalization-to-GDP metric (Cap/GDP) metric is useful.
This metric was popularized by Warren Buffett two decades ago. The way it works, is you divide the total market capitalization (approximated by the Wilshire 5000 index in the United States) 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 is the logarithmic chart of market capitalization, GDP, and broad money supply:
Chart Source: St. Louis Fed
And here is the chart of the market cap to GDP ratio itself:
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 tax or 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.
- Sector concentration is relevant. A country with a high share of technology companies enjoying fast growth will naturally have a high CAPE. On the other hand, a country mostly concentrated in slow-growing banks will have a lower CAPE. It’s always relative, and important to compare apples to apples.
- If corporations get a larger and larger percentage of their profits from overseas, 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.
Then when you look at normal price-to-earnings, price-to-book, and price-to-sales, you have even more metrics to help determine if a market is overvalued or undervalued. You can also compare the current dividend yield to a longer-term average dividend yield.
I pay attention to CAPE and Cap/GDP closely, as well as other valuation metrics, 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.
This article goes into some detail about how I employ the use of valuation metrics:
Sometimes the U.S. market is a bargain, while other times it’s overvalued. Sometimes other countries are extremely cheap, while sometimes they are expensive.
Right now, most international markets are way cheaper than US markets. They tend to be tilted towards more value-oriented industries (banks, commodity producers, industrials, etc) and if the 2020s ends up being a good decade for those industries, then those foreign indices have a decent chance of outperforming US markets.
Long story short, when markets are cheap relative to their fundamentals and growth prospects, I gradually increase my exposure to equities in those regions and leave myself with a lot of upside potential.
When markets are expensive, I reduce my exposure to equities in those regions, shift some money to alternative assets, and use other strategies to keep my cost basis lower and maintain more protection.
It’s not about big portfolio moves, or relying heavily on any given metric. It’s about gradual, small moves, and taking into account numerous valuation metrics and multiple long-term research examples of why they’re relevant and what they can tell us about forward returns.