Cyclically Adjusted Price-to-Earnings ratio (CAPE ratio)

1. Cyclically Adjusted Price-to-Earnings Ratio (CAPE Ratio)

The Cyclically Adjusted Price-to-Earnings ratio, widely known as the CAPE ratio, Shiller P/E ratio, or P/E10 ratio, is a valuation measure used to assess whether the stock market is overvalued, undervalued, or fairly valued. Developed by Nobel laureate Robert Shiller, it aims to overcome the limitations of the traditional Price-to-Earnings (P/E) ratio by accounting for the cyclical nature of earnings. This article provides a comprehensive overview of the CAPE ratio, its calculation, interpretation, historical context, advantages, disadvantages, and its role within broader investment strategies.

Understanding the Limitations of the Traditional P/E Ratio

The traditional P/E ratio is calculated by dividing a company's stock price by its earnings per share (EPS). While seemingly straightforward, it suffers from several drawbacks when used to gauge overall market valuation.

• **Earnings Volatility:** Earnings are not constant. They fluctuate based on economic cycles, industry-specific events, and company-specific factors. A single year's earnings can be atypically high or low, leading to a misleading P/E ratio. A temporary dip in earnings can make stocks appear cheap, while a temporary surge can make them appear expensive.
• **Accounting Practices:** Companies can use different accounting methods, potentially distorting reported earnings. This makes comparisons across companies and over time difficult.
• **Business Cycle Impact:** The P/E ratio tends to be highest at the peak of the business cycle when earnings are high and lowest at the trough when earnings are low. This inverse relationship can create a false sense of security or alarm. Technical analysis often highlights these cyclical patterns.

These limitations mean that relying solely on the traditional P/E ratio for market valuation can be problematic. The CAPE ratio was designed to address these shortcomings.

Calculating the CAPE Ratio

The CAPE ratio aims to smooth out earnings fluctuations by using inflation-adjusted earnings over a 10-year period. Here's the formula:

CAPE Ratio = Price / (Earnings/Share * Inflation Adjustment Factor)

More specifically:

1. **Collect 10 Years of Earnings:** Gather the real (inflation-adjusted) earnings per share for the S&P 500 (or the relevant market index) over the past 10 years. Inflation adjustment is crucial; using nominal earnings would distort the results. The inflation adjustment typically uses the US CPI (Consumer Price Index). 2. **Average Real Earnings:** Calculate the average of these 10 years of real earnings per share. 3. **Divide Current Price by Average Earnings:** Divide the current price of the S&P 500 by the 10-year average of real earnings per share.

The result is the CAPE ratio. The 10-year window is chosen because it is considered long enough to smooth out short-term earnings fluctuations but not so long that it becomes irrelevant due to structural changes in the economy. Fundamental analysis relies heavily on measures like CAPE.

Interpreting the CAPE Ratio

The CAPE ratio is typically interpreted in relation to its historical average. Here’s a general guide:

• **Low CAPE Ratio (Below 15-20):** Suggests the market may be undervalued. Historically, low CAPE ratios have been associated with higher future returns, though this is not a guarantee. Value investing principles often align with investing during periods of low CAPE ratios.
• **Moderate CAPE Ratio (15-25):** Indicates the market may be fairly valued. This range suggests that future returns are likely to be around the historical average.
• **High CAPE Ratio (Above 25-30):** Suggests the market may be overvalued. Historically, high CAPE ratios have been associated with lower future returns. This doesn't necessarily mean a crash is imminent, but it suggests that investors should be more cautious. Risk management becomes particularly important in these conditions.

It's important to remember that these are just general guidelines. The appropriate interpretation of the CAPE ratio depends on a variety of factors, including the prevailing economic conditions, interest rates, and investor sentiment. Understanding market sentiment is crucial for interpreting valuation metrics.

Historical Context of the CAPE Ratio

The CAPE ratio has a long historical record, dating back to the late 19th century. Analyzing its historical values provides valuable insights into market valuations.

• **Late 19th/Early 20th Century:** CAPE ratios were generally low, often below 10, reflecting a less mature and less speculative market.
• **Great Depression (1930s):** CAPE ratios plummeted to extremely low levels as earnings collapsed during the Depression.
• **Post-World War II (1950s-1960s):** CAPE ratios remained relatively low and stable, averaging around 15-20.
• **1970s:** High inflation and economic uncertainty led to more volatile CAPE ratios.
• **1990s (Dot-Com Bubble):** CAPE ratios rose sharply during the dot-com bubble, reaching levels not seen since the 1920s. This was followed by a significant market correction. Bubble analysis is often employed to identify such periods.
• **2000s (Post-Dot-Com & Financial Crisis):** CAPE ratios declined after the dot-com bubble burst, but then rose again leading up to the 2008 financial crisis.
• **2010s-Present:** CAPE ratios have generally remained high throughout the 2010s and into the 2020s, particularly following the COVID-19 pandemic and subsequent economic stimulus. Periods of low interest rates have contributed to elevated CAPE ratios.

Examining this historical data highlights the CAPE ratio’s tendency to revert to the mean over the long term. However, the timing of these reversals is unpredictable.

Advantages of the CAPE Ratio

• **Smoothes Earnings Volatility:** The 10-year average of earnings helps to mitigate the impact of short-term fluctuations, providing a more stable valuation measure.
• **Accounts for Inflation:** Using real (inflation-adjusted) earnings ensures that the CAPE ratio reflects true purchasing power.
• **Long-Term Perspective:** The focus on a 10-year period encourages a long-term investment horizon.
• **Historical Predictive Power:** Historically, the CAPE ratio has shown some ability to predict long-term market returns, although it is not a perfect predictor. Long-term investing strategies often incorporate CAPE ratio analysis.
• **Simple to Calculate:** While data collection can be time-consuming, the calculation itself is relatively straightforward.

Disadvantages of the CAPE Ratio

• **Not a Precise Timing Tool:** The CAPE ratio is not effective at predicting short-term market movements. It can remain high for extended periods before a correction occurs.
• **Structural Changes in the Economy:** The economy has undergone significant structural changes over the past century. These changes, such as the increasing importance of intangible assets and globalization, may have altered the relationship between earnings and stock prices.
• **Accounting Changes:** Changes in accounting standards can affect reported earnings, making historical comparisons difficult.
• **Low Interest Rate Environment:** Low interest rates can justify higher CAPE ratios, as investors are willing to pay more for earnings when alternative investment options offer lower returns. Macroeconomic analysis is essential for understanding the impact of interest rates.
• **Sectoral Shifts:** Changes in the composition of the S&P 500 (e.g., a greater weighting towards high-growth, low-earnings companies) can affect the overall CAPE ratio. Sector rotation strategies should be considered alongside CAPE ratio analysis.
• **Doesn't Account for Debt:** The CAPE ratio focuses solely on earnings and doesn’t consider corporate debt levels, which can significantly impact financial health. Credit analysis is important alongside CAPE.
• **Backward-Looking:** The CAPE ratio is based on historical earnings, which may not be indicative of future performance. Forecasting techniques should be used to supplement CAPE ratio analysis.

CAPE Ratio and Other Valuation Metrics

The CAPE ratio should not be used in isolation. It is best used in conjunction with other valuation metrics, such as:

• **Price-to-Book (P/B) Ratio:** Measures a company's market capitalization relative to its book value.
• **Price-to-Sales (P/S) Ratio:** Measures a company's market capitalization relative to its revenue.
• **Dividend Yield:** Measures the annual dividend income relative to the stock price.
• **Tobin's Q Ratio:** Compares a firm's market value to the replacement cost of its assets.
• **Earnings Yield:** The inverse of the P/E ratio.
• **Cyclically Adjusted Earnings Yield (CAEY):** The inverse of the CAPE ratio. Often provides a more intuitive perspective.
• **Shiller's P/B Ratio:** Similar to the CAPE ratio but uses average inflation-adjusted book value instead of earnings.
• **Gross Domestic Product (GDP) to Market Capitalization Ratio (Buffett Indicator):** Compares the total market capitalization of publicly traded companies to the US GDP. Economic indicators are vital for a holistic view.

Combining these metrics provides a more comprehensive assessment of market valuation. Portfolio diversification can mitigate risks associated with relying on a single valuation metric.

Using the CAPE Ratio in Investment Strategy

Investors can use the CAPE ratio in several ways:

• **Long-Term Asset Allocation:** Adjust portfolio allocations based on the CAPE ratio. Reduce equity exposure when the CAPE ratio is high and increase it when the CAPE ratio is low.
• **Value Investing:** Identify undervalued stocks or markets with low CAPE ratios.
• **Market Timing (with Caution):** Attempt to time market entries and exits based on the CAPE ratio, but recognize the limitations of this approach. Algorithmic trading can be used to automate market timing strategies based on CAPE.
• **Risk Management:** Use the CAPE ratio as a warning signal of potential market overvaluation. Reduce portfolio risk or increase cash holdings when the CAPE ratio is high.
• **Contrarian Investing:** Go against the prevailing market sentiment when the CAPE ratio suggests the market is mispriced. Behavioral finance helps explain market irrationality.
• **Trend Following:** Incorporate CAPE ratio signals into trend following strategies. Moving averages can be combined with CAPE to confirm trend strength.

However, it’s critical to remember that the CAPE ratio is just one piece of the puzzle. It should be used in conjunction with other analytical tools and a sound understanding of the economic environment. Financial modeling can help assess the potential impact of different CAPE ratio scenarios.

Resources for Tracking the CAPE Ratio

• **Robert Shiller's Website:** [1] Provides historical CAPE ratio data and analysis.
• **AdvisorShares:** [2] Offers tools and insights related to the CAPE ratio.
• **GuruFocus:** [3] Tracks the CAPE ratio and provides related data.
• **Investopedia:** [4] Provides a clear explanation and definition of the CAPE Ratio.
• **Macrotrends:** [5] Shows a historical chart of the CAPE ratio.
• **TradingView:** [6] Presents a visual representation of the CAPE ratio for the S&P 500.

Conclusion

The Cyclically Adjusted Price-to-Earnings (CAPE) ratio is a valuable tool for assessing market valuation. While it has limitations, its long-term historical record and ability to smooth out earnings volatility make it a useful addition to any investor's toolkit. By understanding its strengths and weaknesses and using it in conjunction with other valuation metrics, investors can gain a more informed perspective on the potential risks and opportunities in the stock market. Portfolio management should always be based on a comprehensive analysis of various factors, including the CAPE ratio.

Start Trading Now

Sign up at IQ Option (Minimum deposit $10) Open an account at Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to receive: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners