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 formula: 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). The primary objective of the CAPE ratio is to identify if the security in question is overvalued, undervalued, or fairly valued. It compares the current SPX price to its inflation-adjusted historical earnings record. The ratio assesses the future returns of the SPX Index from a longer-term perspective, typically 10 to 20 years.
Provides a better picture of longer-term earnings potential.
One of the primary reasons an investor favors the CAPE ratio over the popular P/E ratio is the average earnings over the last decade smooth out the fluctuations of business cycles and volatile events, providing a clearer picture of the longer-term earnings potential and valuations.
The objective of the CAPE ratio is not to predict stock market crashes, although unusually high CAPE readings have produced historic market tops in the past. It seeks to value the SPX Index and gauge the future returns of SPX over the longer term (i.e., 10 to 20 years). Higher than average CAPE ratios today imply lower than average long-term average SPX returns in the future. Conversely, lower than average CAPE ratios today suggest higher than average long-term average SPX returns in the future.
Shortfalls of the CAPE ratio
Academics and investment professionals have criticized Shiller’s CAPE ratio as it lacks precision in forecasting market tops or bottoms. CAPE has shown to have an inherent bias to underestimate future returns. It tends to be overly pessimistic since it does not reflect earnings as they are calculated based on current accounting rules and practices.
Another criticism of the CAPE ratio is that it misses market tops or bottoms because it does not incorporate risk-free interest rates into its equation. P/E ratios are much higher due to the 40-plus-year secular downtrend in global interest rates. With interest rates reversing their structural downtrends, will CAPE be more dependable?
As interest rates rise, the dividend yield trend also climbs. Since the CAPE ratio does not incorporate changes in the dividend yields, it will not underestimate future SPX returns. Another shortfall in using the CAPE ratio is most businesses and industries are structurally different today than when Shiller introduced the concept years ago (i.e., technology-driven, work-from-home trends, e-commerce, social media, etc.).
Technical Review of the CAPE ratio
The enclosed yearly chart of the CAPE ratio for the SPX Index shows that at the current CAPE of 28.90 (July 2022), the ratio has stalled in November 2021 high at 38.58 or just shy of the 2000 tech/telecom dot.com high (43.77). In the past six months, SPX has fallen 1,181.75 points or 24.5%, and CAPE has also declined in sympathy. CAPE is trading at a critical juncture just below the top of its structural uptrend channel (i.e., black dash line = 29.5).
In the past, the CAPE has peaked near the top of its long-term uptrend channel. It occurred four times, during 1881 at 18.47, 1937 at 21.62, 1966 at 24.06, and 2004 at 27.66.
Except for three occasions - the Roaring 20s, Tech/Telecom dot.com, and 2017-present, each of the previous peaks signaled a top and the beginning of a sustainable decline in the CAPE ratio and the SPX price.
Will the previous resistance zone now act as pivotal support?
What happens if CAPE does not rebound from this support?
When the CAPE ratio exceeded the top of its secular uptrend channel, it triggered two spectacular stock market bubbles as the CAPE ratio dramatically overshot to the upside.
For example, toward the end of the roaring 20s secular bull run in 1929, CAPE rallied to an extreme high of 27.08 before peaking. Also, during the later stage of the dot.com bubble in 2000, CAPE skyrocketed to an unprecedented high of 43.77 before sharply reversing direction.
Despite the recent market setback, the CAPE ratio may be trading at an overvalued level, and if so, how low can CAPE fall below a sustainable SPX bottom?
As noted by its critics, unusually low-interest rates can lead to false readings of the long-term SPX earnings potential, resulting in CAPE overshooting to the upside for only the third time in the past 150 years.
However, with FED tightening monetary policies, ongoing supply bottlenecks, soaring inflation, geopolitical tensions in Russia and Ukraine, and stagflation concerns, interest rates may be reverting to the historical norm. Will this improve the reliability of the CAPE ratio?
One final thought - the linear regression line for the CAPE ratio is rising near 25.5. Given the sharp deceleration in CAPE over the past eight (8) months, a retest of the mid-20s is reasonable.
Will a decline in CAPE toward the linear regression line lead to SPX retesting critical support in the low-to-mid 3,000s?
What happens if CAPE does not find support in the mid-20s and SPX fails to rebound from the low-to-mid 3,000s.
Does this imply a CAPE and SPX decline toward the bottom of their structural uptrend channels at 16.5 and 2,750-2,800, respectively?