What is the CAPE ratio?
American economist and Nobel Laureate Robert Shiller introduced the popular financial ratio to the Federal Reserve in December 1996. The cyclically adjusted price-to-earnings ratio or CAPE, Shiller P/E, or P/E 10 ratio is a fundamental valuation measure often applied to market indexes such as the S&P 500 Index.
How to Calculate the CAPE ratio?
CAPE ratio for SPX is a variation of the commonly used price-to-earnings ratio (P/E). The calculation is: Divide the current price of the SPX Index by the average of the past ten years of earnings, adjusted for inflation using the consumer price index (CPI).
Provides a Better Picture of SPX's Longer-term Earnings Potential?
One of the primary reasons an investor would consider CAPE over the popular P/E ratio is that utilizing the average earnings over the last decade helps to smooth out the fluctuations of business cycles and other volatile events. Many believe this will provide a clearer picture of SPX's longer-term earnings potential.
Contrary to widespread beliefs, the objective of the CAPE ratio is not to predict stock market crashes, although unusually high CAPE readings led to market tops in the past.
The CAPE ratio is best used to value the SPX Index and gauge the likely future returns of SPX over 10 to 20 years. Higher-than-average CAPE ratios typically imply lower-than-average long-term annual SPX returns. Conversely, lower-than-average CAPE ratios suggest higher-than-average long-term annual average SPX returns.
Shortfalls of the CAPE ratio
Critics argue Shiller's CAPE ratio cannot accurately forecast market tops or bottoms. CAPE has been shown to have an inherent bias to underestimate future returns. It tends to be overly pessimistic since it does not reflect how earnings are calculated based on current accounting rules and practices.
CAPE ratio is not accurate in identifying market tops or bottoms since it does not incorporate risk-free interest rates into its equation. With historically low interest rates in the U.S. and globally, this criticism has gained traction among its defectors.
As interest rates decline, the dividend yield trend falls as well. Since the CAPE ratio does not incorporate changes in the dividend yields, it can underestimate future SPX returns. P/E ratios are much higher today due to the 40-plus-year secular downtrend in global interest rates. When interest rates normalize toward higher yields, will the CAPE ratio gain traction?
Another shortfall in using the CAPE ratio is that most businesses and industries are structurally different today than when Shiller first invented the ratio many years ago (i.e., work-from-home trend, AI, e-commerce, social media, etc.).
The Shiller PE can help investors to decide their investment strategies based on different market valuations. The primary objective of the CAPE ratio is to gauge if the SPX Index is trading at overvalued, undervalued, or fairly valued levels.
It compares the current SPX price to its inflation-adjusted historical earnings record. The ratio assesses the likely future returns of the SPX Index from a longer-term perspective, typically 10 to 20 years.
Historical market returns prove that when the market is trading at fair or overvalued, it is best to be defensive. Companies with quality business and strong balance sheets tend to perform better. On the other hand, when the market is trading at undervalued levels, it pays to be aggressive and buy depressed companies with robust balance sheets.
Technical Review of the CAPE Ratio
The CAPE ratio for the SPX Index shows a current level of 32.49 (December 2023), implying stocks are overvalued, at least from a historical perspective. CAPE ratio found critical support just above the long-term linear regression line (blue dash line = 25) during October 2022 lows (27.08) and again during Mar 2023 (27.95). CAPE has recently surged to above the top of the structural uptrend channel (i.e., black dash line = 32).
In the past, when the CAPE ratio nears the top of its structural uptrend channel, it tends to peak and reverse direction soon after. It occurred three times in the past, in 1881 at 18.47, in 1937 at 21.62, and in 1966 at 24.06. Each peak led to an SPX market top and the beginning of a sustainable decline in the CAPE ratio and SPX bear market. However, there were also three outliers, including during the 1929 Roaring 20s bubble when the CAPE soared to 27.08, during the 2000 Dot.com bubble when the CAPE exploded to 43.77, and recently during Nov 2021 when the CAPE reached a high of 38.58.
It is also interesting to point out that when the CAPE ratio exceeded the top of its secular uptrend channel, it ignited two speculative stock market bubbles as the CAPE ratio dramatically overshot to the upside. For example, at the end of the roaring 20s secular bull run in 1929, CAPE rallied to an extreme high of 27.08 as the bubble burst. Also, during the later stage of the Dot.com bubble in 2000, CAPE skyrocketed to an unprecedented high of 43.77 before reversing direction.
The question then becomes – with the CAPE ratio currently trading at an overvalued level (32.49), does this imply an SPX peak is imminent?
If SPX repeatedly fails to surpass 4,818.62 (Jan 2022 all-time high) or temporarily breaks out but quickly reverses back below the breakout (false breakout) and the CAPE ratio falls to the regression line (25), does this translate to SPX retesting 3,200-3,500 or lower?
On the other hand, if the CAPE ratio again soared to the Nov 2021 high (38.58) and above this to the 2000 Dot.com bubble high (43.77)?
As noted by some of the critics of the CAPE ratio, exceptionally low-interest rates can lead to false readings of the long-term earnings potential of SPX. However, with inflationary pressures and rising interest rates over the past year, does this reset the CAPE ratio, allowing it to trend even higher, possibly allowing for another overshooting to the upside for only the fourth time in the past 151 years?
One final thought - the CAPE ratio found pivotal support near the long-term linear regression line (25) in the past two years, coinciding with the October 2022 market bottom (SPX = 3,491.58 and CAPE = 27.08) and a higher low on March 2023 (SPX = 3,808.86 and CAPE = 27.95) hints that the CAPE ratio can trend higher.
Will a convincing breakout in SPX above 4,818.62 (Jan 2022 all-time high) coupled with the CAPE ratio retesting the Nov 2021 high of 38.58 and above this to the 2000 Dot.com bubble CAPE ratio high of 43.77 lead to SPX technical projections of 5,100.36 (early 2024), 6,145.66 (2025), and 6,441.96 (2026)?