CAPE Ratio (Shiller P/E)
What Is the CAPE Ratio?
The CAPE Ratio (Cyclically Adjusted Price-to-Earnings) is a valuation metric that uses real (inflation-adjusted) earnings per share over a 10-year period to smooth out fluctuations in corporate profits and provide a long-term view of market valuation.
The CAPE Ratio, short for Cyclically Adjusted Price-to-Earnings Ratio, is a valuation measure used to assess the likely future returns of the stock market. It is also widely known as the Shiller P/E Ratio, named after Yale Professor and Nobel Laureate Robert Shiller, who popularized its use. Unlike the standard P/E ratio, which looks at only one year of earnings (trailing or forward), the CAPE ratio uses a 10-year average of inflation-adjusted earnings. The primary problem with the standard P/E ratio is that corporate earnings are highly volatile. They fluctuate wildly with the business cycle, booming during economic expansions and collapsing during recessions. This volatility can send misleading signals. For instance, during a severe recession, earnings might drop to near zero, causing the P/E ratio to skyrocket even if stock prices have already crashed. Conversely, at the peak of a boom, record earnings can make stocks look artificially cheap just before a crash. To solve this, Shiller adopted the methodology proposed by value investing legends Benjamin Graham and David Dodd. By averaging earnings over a 10-year period, the CAPE ratio "smooths" out these cyclical peaks and troughs. This creates a stable baseline of "normalized" earnings power. Comparing the current price to this stable baseline provides a much more reliable thermometer for market temperature. It tells investors whether the market is expensive or cheap relative to its long-term earnings potential, independent of where we are in the current business cycle. This long-term perspective is essential for strategic asset allocation, helping investors distinguish between temporary market noise and genuine shifts in valuation. By stripping away the distorting effects of inflation and short-term earnings volatility, the CAPE ratio offers a clearer view of underlying market value.
Key Takeaways
- Developed by Nobel Laureate Robert Shiller to assess market valuation over business cycles.
- Calculated by dividing the current price by the average of the last 10 years of inflation-adjusted earnings.
- Smoothes out the volatility of profit margins during booms and busts.
- Historically, high CAPE ratios have predicted lower future returns over the subsequent 10-20 years.
- It is not effective as a short-term market timing tool but is powerful for long-term strategic asset allocation.
- Critics argue that changes in accounting rules and share buybacks may distort historical comparisons.
How the CAPE Ratio Works
The calculation of the CAPE ratio involves a systematic process designed to strip away the noise of inflation and short-term economic fluctuations. The goal is to arrive at a valuation multiple that reflects true purchasing power and sustainable earning capacity. The process begins by gathering the reported earnings per share (EPS) for the market index (typically the S&P 500) for each of the past 10 years. This decade-long window is chosen specifically because it is generally long enough to encompass at least one full business cycle, ensuring the data includes both recessionary and expansionary environments. Next, each year's earnings figure is adjusted for inflation using the Consumer Price Index (CPI). This is a critical step because a dollar earned 10 years ago is not worth the same as a dollar earned today. By adjusting all historical earnings into "current dollars," the metric ensures an apples-to-apples comparison of profitability over time. Once the inflation-adjusted earnings for all 10 years are calculated, they are averaged to produce the "cyclically adjusted" EPS. Finally, the current price of the S&P 500 is divided by this 10-year average. The resulting ratio is the CAPE. A high CAPE suggests the market is overvalued relative to history, while a low CAPE suggests it is undervalued. This methodology provides a "reality check" on current market prices by anchoring them to a decade of realized economic performance rather than optimistic future estimates.
Important Considerations for Investors
While the CAPE ratio is a powerful tool for assessing long-term value, investors must understand its limitations and context. First and foremost, the CAPE ratio is not a timing tool. History shows that the market can remain "overvalued" (with a CAPE above 25 or 30) for years before a correction occurs. The dot-com bubble, for example, saw the CAPE ratio stay elevated for an extended period before the eventual crash. Using it to time entries and exits can lead to missing out on significant gains during the final stages of a bull market. Secondly, structural changes in the economy may affect the "fair value" baseline. The historical average CAPE is around 16-17, but the modern economy is less capital-intensive and more technology-driven, leading to higher profit margins. Additionally, changes in accounting standards and the shift from dividends to share buybacks can distort historical comparisons. Some analysts argue that these factors justify a permanently higher "new normal" for the CAPE ratio, meaning a reading of 25 today might not be as bearish as a reading of 25 was in 1980.
Advantages of Using CAPE
The primary advantage of the CAPE ratio is its ability to filter out short-term noise. Standard valuation metrics are often misleading at market turning points. By using a 10-year average, CAPE provides a view of valuation that is immune to temporary earnings shocks. 1. Long-Term Forecasting: Statistical analysis shows that CAPE is highly correlated with future 10-year returns. When CAPE is low, future returns tend to be high (10-15% annually). When CAPE is high, future returns tend to be low (0-5% annually). 2. Risk Management: It serves as an excellent gauge of market sentiment and risk. An extremely high CAPE warns investors that euphoria has disconnected prices from fundamentals, signaling a time to be cautious or defensive. 3. Inflation Adjustment: Unlike many simple ratios, CAPE explicitly accounts for the erosion of purchasing power, making it a more robust measure of real value over long periods.
Disadvantages and Criticisms
Despite its academic pedigree, the CAPE ratio faces valid criticisms. The most significant is its backward-looking nature. By relying on data from 10 years ago, it may be slow to reflect fundamental improvements in corporate profitability. If companies become permanently more efficient, the 10-year average will "drag down" the earnings denominator, making the ratio look artificially high. Another disadvantage is the impact of payout policy changes. In the past, companies paid out most earnings as dividends. Today, share buybacks are dominant. Buybacks boost EPS growth, which can make historical comparisons tricky if not adjusted for. Furthermore, the CAPE ratio does not account for interest rates. A high P/E ratio is easier to justify when interest rates are near zero (as bonds offer no competition) than when rates are high. Failing to adjust for the interest rate environment can lead to overly bearish conclusions in low-rate eras.
Real-World Example: The 2000 Dot-Com Peak
The most famous validation of the CAPE ratio occurred during the late 1990s technology bubble. As stock prices soared, traditional analysts justified the valuation using "new economy" metrics.
Interpreting CAPE Levels
A general guide to historical CAPE ranges and their implications for future returns.
| CAPE Range | Valuation Status | Historical Context | Implied 10-Year Return |
|---|---|---|---|
| Below 10 | Undervalued | Great Depression (1932), Early 1980s | High (>15% annualized) |
| 10 - 15 | Fair Value | Mid-20th Century Average | Average (~10% annualized) |
| 15 - 25 | Elevated | 1960s, 2003-2007 | Moderate (5-8% annualized) |
| Above 25 | Overvalued | 1929 Peak, 2021 Peak | Low (<5% annualized) |
| Above 30 | Bubble | Dot-Com Bubble (2000) | Negative or Flat |
FAQs
Historically, the average CAPE ratio for the S&P 500 is around 16 to 17. A ratio between 15 and 20 is generally considered fair value. A ratio below 15 suggests the market is undervalued and may offer higher future returns. However, in the modern era of low interest rates and high tech dominance, some analysts argue that a "good" CAPE is now closer to 20-22.
The current CAPE ratio is updated regularly by Professor Robert Shiller on his Yale University website. It is also tracked by major financial news outlets and investment research platforms like Multpl.com and GuruFocus. Investors can check these sources to see where the current market valuation stands relative to historical norms.
No. A high CAPE ratio is not a "sell signal." It indicates that the market is expensive and that future returns over the next 10 years will likely be lower than average. Instead of selling everything, investors might consider rebalancing their portfolio, reducing exposure to overvalued sectors, or lowering their return expectations for their financial planning.
The 10-year period is the standard because it is generally long enough to capture a full business cycle, including at least one recession and one expansion. A 5-year period might only capture a boom (making stocks look cheap) or a bust (making them look expensive). A 20-year period might introduce too much data from a completely different economic era.
While possible, the CAPE ratio is most effective for broad market indices. Individual companies undergo drastic changes over a decade—mergers, acquisitions, business model pivots—that can make 10-year-old earnings irrelevant. For indices like the S&P 500, these individual company risks average out, making the 10-year macro view more valid.
The Bottom Line
The CAPE Ratio is widely regarded as one of the most reliable metrics for assessing long-term market valuation. By smoothing out the volatility of the business cycle and adjusting for inflation, it provides a clearer picture of whether stock prices are grounded in reality or driven by sentiment. While it is a poor tool for short-term trading—markets can remain irrational for years—it is an invaluable compass for long-term investors. A high CAPE warns of lower future returns and higher risk, suggesting a need for caution or defensive positioning. Conversely, a low CAPE has historically signaled generational buying opportunities. Understanding the CAPE ratio helps investors set realistic expectations, avoid the trap of buying at the peak of a bubble, and maintain discipline during periods of market extremes. It reminds us that while prices may fluctuate wildly in the short run, they ultimately gravitate back toward the gravitational pull of long-term corporate earnings.
More in Valuation
At a Glance
Key Takeaways
- Developed by Nobel Laureate Robert Shiller to assess market valuation over business cycles.
- Calculated by dividing the current price by the average of the last 10 years of inflation-adjusted earnings.
- Smoothes out the volatility of profit margins during booms and busts.
- Historically, high CAPE ratios have predicted lower future returns over the subsequent 10-20 years.