The Cyclically Adjusted Price to Earnings Ratio, or CAPE Ratio, is a classic measure of stock market valuation first developed by Yale economist Robert Shiller and discussed extensively in his classic book Irrational Exuberance. The key feature of the CAPE ratio is that it adjusts the earnings of the S&P 500 for inflation and calculates a 10-year average. In this way, the CAPE ratio smooths fluctuations in the business cycle to produce a less volatile measure of market valuation.
Use the below app to explore the CAPE Ratio and how market valuation impacts the outlook for stocks! For more on the CAPE Ratio and how to get the most out of this app please read the article below.
The Theory of Financial Ratios
Financial ratios like Price/Earnings (PE), Price/Book (PB), and Enterprise Value/EBITDA (EV/EBITDA) are commonly used by financial analysts to gauge the relative value of a stock. The Price-to-Earnings (PE) Ratio is perhaps the simplest and most classic measure of a stock’s value. This method for valuing a company measures the current share price relative to earnings per share (EPS). By comparing the PE ratio across stocks, investors can better understand which stocks are expensive and which are cheap. A stock with a high PE ratio might be expected to grow aggressively while a stock with a low PE might help us identify a stock that is attractively valued.
Financial ratios can be expressed on either a trailing or forward-looking basis. The Forward PE is calculated by taking the current price and dividing it by an estimate for earnings over the next 12 months. More commonly the PE is expressed on a trailing basis which takes the current price divided by earnings over the previous 12 months.
The PE for the S&P 500 has averaged about 16 over its 100+ year history but in any one year can deviate significantly. Take a look at the below graph of the PE ratio for 1891-2000. The average might be 16, but the ratio has rarely stayed there for very long and can be quite volatile year to year (or quarter to quarter).
I excluded the 2010’s in the previous graph for a reason. The ’08 Financial Crisis and Great Recession were so severe that for a period of time the trailing 12-month earnings for the S&P were actually negative which had the perverse effect of making stocks look wildly expensive when, in reality, they were historically very cheap.
You can see this dynamic in the graph for the PE ratio from 1926-2020. The PE ratio is significantly distorted during the ’08-’09 period and confounds our understanding of what relative valuations mean for stocks.
In order to smooth out fluctuations in corporate profits due to the business cycle and reduce the volatility of valuations, Noble winning economist Robert Shiller developed the Cyclically Adjusted Price-Earnings (CAPE) Ratio. Professor Shiller first introduced the CAPE in a series of provocative papers in 1998 and 2001. In these two seminal works he concluded that the stock market was historically overvalued and that the ensuing 10 years would produce very poor returns for stocks. This prophetic call on the markets solidified the CAPE Ratio as a critical metric for analyzing the stock market.
Unlike the simple PE ratio, the CAPE ratio takes as the denominator an average of the previous 10-years earnings adjusted for inflation and is defined as follows:
You can see the effect of this adjustment in the below graph which depicts the CAPE ratio for 1891-2022. The volatility of the ratio is significantly reduced and the oddness of 2010’s is replaced by the behavior we would expect (i.e. cheap valuations coming out of recession). One feature of the CAPE that the chart suggests is that valuations are stable.
Stability, Mean Reversion and Valuation
It’s imperative to understand what the stability of a valuation ratio implies about mean reversion. The stability of a valuation ratio (like CAPE) implies that a stock’s valuation will fluctuate within the historical range and not move permanently outside or “get stuck” at historically extreme levels. If we accept this premise, then we effectively claim that valuations are stationary or mean reverting.
It follows that when a valuation ratio is at an extreme level, then, eventually, something must happen to restore a long-term equilibrium. In the case of a CAPE ratio that is historically high, either the numerator (i.e. Price) must decline or the denominator (i.e. Average 10-Year Earnings) must grow to bring the ratio back to the “average” level.
If this is the case, then surely something must be forecastable based on the CAPE; either the numerator or the denominator. Therefore the CAPE must be able to forecast either the future trajectory of prices (the ‘P’) or the future path of earnings (the ‘E’). The Shiller studies and my own work (see Stock Market Valuation and the 2020’s in R) demonstrate that valuations imply nothing about future earnings growth in either the short or long term. While empirically important, valuations have only limited relevance for predicting returns in the short-run. It is only in the long-run that valuations demonstrate their utility and become a major factor for predicting the future direction of markets.