What Is the CAPE Ratio (Shiller P/E Ratio)?

What Is the CAPE Ratio (Shiller P/E Ratio)?

Let me tell you about the CAPE ratio, which you might also know as the Shiller P/E ratio. It evaluates the stock market's pricing by taking past earnings, adjusting them for inflation, and averaging them over a full decade. This approach, brought into the spotlight by Yale economist Robert Shiller, helps you figure out if markets are undervalued or overvalued based on solid historical earnings data.

Key Takeaways

You need to understand that the CAPE ratio, or Shiller P/E, relies on real earnings per share averaged over 10 years to account for economic cycles, giving you a clear way to assess market valuation. Robert Shiller popularized this tool, and it directly helps you evaluate if individual stocks or broad equity indexes are undervalued or overvalued. Keep in mind, though, that critics point out its limitations in predicting future returns because it's backward-looking and tied to GAAP earnings. Historically, when the CAPE ratio hits high levels, it often signals upcoming market corrections, as seen in 1997 and proven during the 2008 crash.

How to Calculate the CAPE Ratio

Calculating the CAPE ratio is straightforward: you divide the current share price by the average inflation-adjusted earnings over the past 10 years. The formula looks like this: CAPE ratio = Share price / (10-year average, inflation-adjusted earnings). This gives you a metric that's adjusted for economic ups and downs.

Understanding the Insights From the CAPE Ratio

Economic cycles have a big impact on company profits, and you should recognize that. In expansions, profits soar as consumers spend freely, but in recessions, spending drops, profits plummet, and losses can occur. This effect is stronger in cyclical sectors like commodities and financials, while utilities tend to be more stable. Still, most companies face challenges staying profitable in deep recessions.

These earnings fluctuations make traditional P/E ratios swing wildly, which is why Benjamin Graham and David Dodd, in their 1934 book 'Security Analysis,' advised using an average of earnings over seven or 10 years for valuation. That's the core idea behind the CAPE ratio—smoothing out those swings to give you a reliable view.

Real-World Example of CAPE Ratio Application

The CAPE ratio really caught attention in December 1996 when Robert Shiller and John Campbell presented data to the Federal Reserve showing stock prices outpacing earnings. By 1998, they published research averaging the S&P 500's real earnings over 10 years, dating back to 1872.

At that time, the ratio hit a record 28 in January 1997, matching levels only seen in 1929. They predicted the market's real value would drop 40% in 10 years, and that turned out accurate with the 2008 crash, where the S&P 500 fell 60% from October 2007 to March 2009.

In recent years, the CAPE for the S&P 500 has climbed as the U.S. economy recovered and stocks hit records. As of June 2024, it stands at 35.49 against a long-term average of 16.80. Since it only topped 30 in 1929 and 2000 before, this has fueled debates on whether a major correction is coming.

Recognizing the Limitations of the CAPE Ratio

Critics argue the CAPE ratio isn't that useful because it focuses on historical data rather than future trends. Another problem is its dependence on GAAP earnings, which have changed significantly over time.

In a 2016 paper, Jeremy Siegel from the Wharton School noted that using CAPE for future return forecasts might be too pessimistic due to these GAAP shifts. He suggested that consistent data like operating earnings or NIPA profits could improve the model's predictions for higher U.S. equity returns.

What Does CAPE Stand for in CAPE Ratio?

CAPE stands for cyclically adjusted price-to-earnings. You know it as the Shiller P/E ratio, named after Yale professor Robert Shiller who made it popular.

What Is the CAPE Ratio Applied to?

You typically apply the CAPE ratio to broad equity indexes to check if the market is undervalued or overvalued. But remember, critics say it's not very helpful since it's backward-looking and based on GAAP earnings that have evolved.

When Did the CAPE Ratio First Gain Public Attention?

It first gained notice in December 1996 when Shiller and Campbell showed the Federal Reserve that stock prices were growing faster than earnings. They followed up in 1998 with their article 'Valuation Ratios and the Long-Run Stock Market Outlook.'

The Bottom Line

The cyclically adjusted price-to-earnings ratio, or CAPE, smooths profit fluctuations by using real EPS over 10 years, adjusted for inflation. Robert Shiller popularized it to help you determine market overvaluation or undervaluation. It's a key tool for long-term analysis, but you should note criticisms about its backward focus and reliance on changing GAAP standards. Consider these points when using the CAPE ratio for your market decisions.