Cyclically adjusted price-to-earnings ratio
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The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the US
S&P 500 The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of D ...
equity market. It is defined as price divided by the average of ten years of earnings (
moving average In statistics, a moving average (rolling average or running average) is a calculation to analyze data points by creating a series of averages of different subsets of the full data set. It is also called a moving mean (MM) or rolling mean and is ...
), adjusted for inflation. As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns. The ratio was invented by American economist
Robert Shiller Robert James Shiller (born March 29, 1946) is an American economist, academic, and author. As of 2019, he serves as a Sterling Professor of Economics at Yale University and is a fellow at the Yale School of Management's International Center fo ...
. The ratio is used to gauge whether a stock, or group of stocks, is undervalued or overvalued by comparing its current market price to its inflation-adjusted historical earnings record. It is a variant of the more popular price to earning ratio and is calculated by dividing the current price of a stock by its average inflation-adjusted earnings over the last 10 years. Using average earnings over the last decade helps to smooth out the impact of business cycles and other events and gives a better picture of a company's sustainable earning power. It is not intended as an indicator of impending market crashes, although high CAPE values have been associated with such events.


Background

Value investors
Benjamin Graham Benjamin Graham (; né Grossbaum; May 9, 1894 – September 21, 1976) was a British-born American economist, professor and investor. He is widely known as the "father of value investing", and wrote two of the founding texts in neoclassical inves ...
and
David Dodd David LeFevre Dodd (August 23, 1895 – September 18, 1988) was an American educator, financial analyst, author, economist, and investor. In his student years, Dodd was a ' and colleague of Benjamin Graham at Columbia Business School. The Wall ...
argued for smoothing a firm's earnings over the past five to ten years in their classic text ''
Security Analysis Security analysis is the analysis of tradeable financial instruments called securities. It deals with finding the proper value of individual securities (i.e., stocks and bonds). These are usually classified into debt securities, equities, or som ...
''. Graham and Dodd noted one-year earnings were too volatile to offer a good idea of a firm's true earning power. In a 1988 paper economists
John Y. Campbell John Young Campbell (born May 17, 1958) is a British-American economist. He is the Morton L. and Carole S. Olshan Professor of Economics at the Department of Economics at Harvard University since 1994. Biography Early years Campbell was born in ...
and
Robert Shiller Robert James Shiller (born March 29, 1946) is an American economist, academic, and author. As of 2019, he serves as a Sterling Professor of Economics at Yale University and is a fellow at the Yale School of Management's International Center fo ...
concluded that "a long moving average of real earnings helps to forecast future real dividends" which in turn are correlated with returns on stocks. The idea is to take a long-term average of earnings (typically 5 or 10 year) and adjust for inflation to forecast future returns. The long term average smooths out short term volatility of earnings and medium-term business cycles in the general economy and they thought it was a better reflection of a firm's long term earning power. From the 1940s,
Sir John Templeton Sir John Marks Templeton (29 November 1912 – 8 July 2008) was an American-born British investor, banker, fund manager, and philanthropist. In 1954, he entered the mutual fund market and created the Templeton Growth Fund, which averaged grow ...
used a method adapted from Graham and Dodd, and somewhat similar to the later Shiller P/E, but with the
Dow Jones Industrial Index The Dow Jones Industrial Average (DJIA), Dow Jones, or simply the Dow (), is a stock market index of 30 prominent companies listed on stock exchanges in the United States. The DJIA is one of the oldest and most commonly followed equity inde ...
. Shiller later popularized the 10-year version of Graham and Dodd's P/E as a way to value the stock market as measured by the
S&P 500 The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of D ...
. Shiller would share the Nobel Memorial Prize in Economic Sciences in 2013 for his work in the empirical analysis of asset prices.


Use in forecasting future returns

Using market data from both estimated (1881–1956) and actual (1957 onward) earnings reports from the S&P index, Shiller and Campbell found that the lower the CAPE, the higher the investors' likely return from equities over the following 20 years. The average CAPE value for the 20th century was 15.21; this corresponds to an average annual return over the next 20 years of around 6.6 per cent. CAPE values above this produce corresponding lower returns, and vice versa. In 2014, Shiller expressed concern that the prevailing CAPE of over 25 was "a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks" (ref 4). A high CAPE ratio has been linked to the phrase "
irrational exuberance "Irrational exuberance" is the phrase used by the then-Federal Reserve Board chairman, Alan Greenspan, in a speech given at the American Enterprise Institute during the dot-com bubble of the 1990s. The phrase was interpreted as a warning that the ...
" and to Shiller's book of the same name. After Fed President
Alan Greenspan Alan Greenspan (born March 6, 1926) is an American economist who served as the 13th chairman of the Federal Reserve from 1987 to 2006. He works as a private adviser and provides consulting for firms through his company, Greenspan Associates LLC. ...
coined the term in 1996, the CAPE ratio reached an all-time high during the 2000 dot-com bubble. It also reached a historically high level again during the housing bubble up to 2007 before the crash of the
great recession The Great Recession was a period of marked general decline, i.e. a recession, observed in national economies globally that occurred from late 2007 into 2009. The scale and timing of the recession varied from country to country (see map). At ...
. However, Shiller's views on what CAPE value is a predictor of poor returns have been criticized as overly pessimistic and based on the original definition of CAPE, which fails to take into account changes in accounting standards in 1990s, which, according to
Jeremy Siegel Jeremy James Siegel (born November 14, 1945) is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania in Philadelphia, Pennsylvania. Siegel comments extensively on the economy and financial markets. He ...
, produce understated earnings. The measure exhibits a significant amount of variation over time, and has been criticized as "not always accurate in signaling market tops or bottoms". One proposed reason for this time variation is that CAPE does not take into account prevailing risk-free interest rates. A common debate is whether the inverse CAPE ratio should be further divided by the yield on 10 year Treasuries. This debate regained currency in 2014 as the CAPE ratio reached an all-time high in combination with historically very low rates on 10 year Treasuries.


CAPE for other equity markets

Originally derived for the US equity market, the CAPE has since been calculated for 15 other markets. Research by Norbert Keimling has demonstrated that the same relation between CAPE and future equity returns exists in every equity market so far examined. Research by others has also found CAPE ratios are reliable in estimating market returns over five to ten year periods in many international stock markets. Sébastien Lleo and William T. Ziemba. Predicting Stock Market Crashes in China. The Journal of Portfolio Management Spring 2018, 44 (5) 125-135; DOI: https://doi.org/10.3905/jpm.2018.1.078 It also suggests that comparison of CAPE values can assist in identifying the best markets for future equity returns beyond the US market.


See also

*
Price–earnings ratio The price-earnings ratio, also known as P/E ratio, P/E, or PER, is the ratio of a company's share (stock) price to the company's earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or under ...


References


External links

Robert J. Shiller Robert James Shiller (born March 29, 1946) is an American economist, academic, and author. As of 2019, he serves as a Sterling Professor of Economics at Yale University and is a fellow at the Yale School of Management's International Center for ...
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