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). It is calculated as follows: 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 gauge if the SPX Index is overvalued, undervalued, or fairly valued. It does so by comparing its 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.
Provides a Better Picture of SPX's Longer-term Earnings Potential?
One of the primary reasons why an investor would consider CAPE over the normal 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 that this will provide an investor a clearer picture of SPX's longer-term earnings potential and valuations.
Contrary to widespread beliefs, the objective of the CAPE ratio is not to predict stock market crashes, although unusually high CAPE readings have been associated with major market tops in the past. As mentioned, it is principally 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 average SPX returns. Conversely, lower than average CAPE ratios suggest higher than average long-term annual average SPX returns.
Shortfalls of the CAPE ratio
Shiller's CAPE ratio has been criticized by academics and investment professionals as not accurate in signaling 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 the way earnings are calculated based on current accountant rules and practices.
Another criticism of the CAPE ratio is that it 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 around the world, this criticism has gained traction among its defectors. P/E ratios are much higher today due to the 40-plus year secular downtrend in global interest rates.
Also, 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. Another shortfall of using the CAPE ratio is that most businesses and industries are structurally different today than when Shiller's first introduce it many years ago (i.e., work-from-home trend, e-commerce, social media, etc.).
Technical Review of the CAPE ratio
The yearly chart of the CAPE ratio for the SPX Index shows that at the current level of 34.88 (February 2021) the stock market may be overvalued. It has quickly surged above the top of the structural uptrend channel (i.e., black dash line - 29). When the CAPE ratio approaches the top of its uptrend channel, it has peaked and subsequently contracted soon after. It occurred four times in the past, during 1881 at 18.47, 1937 at 21.62, 1966 at 24.06, and recently in 2004 at 27.66. Each peak warned of an SPX market top and the beginning of a sustainable decline in the CAPE ratio and the SPX price.
However, it is also interesting to point out that when the CAPE ratio exceeded the top of its secular uptrend channel, it has triggered two speculative stock market bubbles as the CAPE ratio overshoot 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 before peaking. During the later stage of the dot.com bubble in 2000, CAPE skyrocketed to an unprecedented high of 43.77 before sharply reversing direction.
The question remains is the CAPE ratio trading at an overvalued level, and is an SPX top is imminent?
As noted by some of the critics of the CAPE ratio, very low-interest rates can lead to false readings to the long-term earnings potential of SPX. The above structural trend coupled with the paradigm shift toward the work-from-home theme, the aggressive monetary response from the FED, and the massive fiscal spending policies in response to the COVID-19 pandemic may have accelerated the CAPE ratio to possibly overshoot to the upside for only the third time in the past 149 years.
One final thought worth mentioning - the CAPE ratio rebounding strongly from the top of its secular uptrend channel during 2016 at 24.21, coupled with the recent surge above its 2018 high of 33.31, suggests the CAPE ratio can trend higher. Will the CAPE ratio retest its 2000 Dot.com bubble CAPE ratio high of 43.77 before finally topping? Does this then imply the SPX Index can continue to set new all-time highs prompting another speculative rally before its peak?