Summary: The CAPE ratio, developed by economist Robert Shiller, has a remarkable track record. It provides a rough-and-ready starting point for warning when markets are becoming either over- or underpriced. Click through to learn exactly how this little-known ratio can help you.
Like a traffic light, the CAPE metric flashes clear red and green signals. When the S&P 500 Shiller CAPE rises over a 30 threshold, the red light suggests that prices are becoming too elevated; when it sinks below 22, markets may soon see bargains. Sound idiot-proof? Remember it only speaks to expected future returns, so it is not a shortcut for timing markets.
It can deliver a powerful reality check. In the spring of 2009, after the turbulence of the financial crisis, the S&P seemed astronomically expensive, with a 123 price-to-earnings ratio. The CAPE, however, said no. It stood at a paltry 13.3, its lowest level in years. The CAPE proved right: It was a brilliant time to invest.
Putting the formula to work
The cyclically adjusted price-to-earnings ratio does exactly what the name spells out. A traditional P/E measurement relates a company’s stock price to its earnings per share on a trailing basis, usually the most recent 12-month period. The CAPE attempts to improve on this methodology. It takes the average of the past 10 years, adjusts for inflation and divides that average into the current price. Consequently, one stellar year or one rotten season no longer skews the calculation.
Robert Shiller, a Yale economics professor, had noted that during economic expansions companies would likely be enjoying robust earnings, resulting in a misleading P/E, with an artificially inflated denominator for earnings. The goal of his CAPE, therefore, was to iron out the fluctuations caused by variations in profit margins during business cycles. During a recession, by contrast, both stock prices and corporate earnings break down.
Shiller has now gone a step further. He refined a new valuation, known as the Excess CAPE Yield, to introduce the element of shifting interest rates into the mix. Basically, when interest rates go down, investors use a lower discount rate for their valuations, which results in higher stock prices and CAPE ratios.
A superb record
During the dotcom bubble mania, Shiller became a vocal prophet in the wilderness, crying that stock prices were too high. Having back-tested 130 years of market data, he could also demonstrate that the next 20 years of returns would probably be inversely correlated with his CAPE ratio.
Since 1870, the CAPE has only exceeded 30 during five periods, and in each case, the S&P or Dow Jones Industrial Average declined by 20% or much more. In 1929, after the Roaring ’20s, prices eventually lost 89% into the next decade. In more recent memory, in 2001, the CAPE reached 44.2, with the S&P tumbling 49%. In 2018, the CAPE soared above 30, and the S&P shed 19.8%. Finally, two months before COVID-19 struck, the CAPE vaulted again, to over 40. In a short but terrifying chute, the S&P crashed 26%.
The CAPE, like all tools, has limitations. Being backward-looking, it depends on sustained conditions. For instance, it can veer off course if tax or accounting rules such as GAAP change.
Around the world
The CAPE works for other markets beyond the S&P 500, or as a metric for individual sectors. In the fourth quarter of 2022, health care, technology, energy, consumer cyclicals and real estate are all sailing over a lofty 30, while financial services are sporting a modest level. It is a viable indicator for countries, too. Note that since different countries follow their own capital market cycles, it must be utilized within the context of their own historical averages.
To give a snapshot, as of July 2022, the U.K. stood at 19.31, Spain at 15.26, Japan at 14, Australia at 20 and India at a rich 29.88. Russia came out at the bottom at 4.68, but that market obviously remains unavailable.
Of course, investors should not rely exclusively on the CAPE. They need to include it alongside other indicators. Your financial adviser can help you construct your portfolio using a mix of the most suitable analyses.