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). To calculate the CAPE ratio, you divide the current price of the SPX Index by the average of the past ten years of earnings, adjusted for inflation (i.e., consumer price index (CPI)). The primary objective of the CAPE ratio is to gauge if the SPX Index is overvalued, undervalued, or fairly valued 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.
Better Picture of SPX's Longer-term Earnings Potential?
One of the primary reasons why an investor would consider CAPE over using the more 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. It provides 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. However, unusually high CAPE readings have led to stock market tops in the past. The primary focus of CAPE is 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 in the future.
Shortfalls of the CAPE ratio
Critics of Shiller's CAPE ratio suggest it is simply not precise enough to identify market tops or bottoms. CAPE tends to have an inherent bias to underestimate future returns. It can be overly pessimistic since it does not reflect future earnings accurately as they are calculated based on current accountant rules and practices.
Another criticism of the CAPE ratio is it is not accurate in identifying market tops or bottoms since it incorporates 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. P/E ratios are much higher today due to the 40-plus-year secular downtrend in global interest rates. Will this premise soon change as interest rates begin to trend higher?
Also, as interest rates decline, the dividend yield trend falls. Since the CAPE ratio does not incorporate changes in the dividend yields, it can underestimate future SPX returns.
Another shortfall in using the CAPE ratio is most businesses and industries are structurally different today than many years ago due to the work-from-home trends, e-commerce, social media, technology, medical innovations, etc.).
Technical Review of the CAPE ratio
The yearly chart of the CAPE ratio for the SPX Index shows that it has peaked at 38.58 (Nov 2021), coinciding with the record highs in stock market indexes (i.e., Nasdaq Composite, NDX 100, and other growth/technology sectors).
The pertinent question remains – at a current CAPE reading of 28.00 (Oct 2022), is the stock market still overvalued?
A review of the CAPE Ratio chart suggests two well-defined dominant uptrends since 1872. It is uncanny that these two structural uptrend channels have alerted investors when SPX is overvalued (upper trend line or the black line) and undervalued (lower trend line or the green line).
When the CAPE ratio approaches the top of its uptrend channel, CAPE subsequently peaks and then contracts. It occurred four times – in 1881 at a CAPE ratio of 18.47, in 1937 at 21.62, in 1966 at 24.06, and in 2004 at 27.66. Each peak warned of an impending SPX market top and the beginning of a sustainable decline in the CAPE ratio and an SPX bear decline.
Interestingly, when the CAPE ratio exceeded the top of its secular uptrend channel, it triggered two speculative stock market bubbles as the CAPE ratio would accelerate exponentially. For example, at the end of the roaring 20s secular bull run from 1921-1929, CAPE rallied to an extreme high of 27.08 before collapsing. Also, during the later stage of the dot.com bubble in 2000, CAPE skyrocketed to an unprecedented high of 43.77 before sharply reversing lower.
With the CAPE ratio peaking in Nov 2021 high (38.58) and breaking the top of its uptrend channel (around 32), where will it find support?
As noted by the critics of the CAPE ratio, very low-interest rates may have inflated the long-term earnings potential of SPX.
Paradigm shifts toward the work-from-home phenomenon, FED QE programs, and Congress's massive fiscal spending policies in response to the COVID-19 pandemic may have also accelerated the CAPE ratio to an unsustainable level (CAPE reached a high of 38.58 in Nov 2021), prompting the fourth sharp downturn in the CAPE ratio in the past 150 years.
One final thought worth mentioning - the CAPE linear regression line or the best fit line (blue dash line) is currently rising near 27. Is this a critically important support zone, as it represents the statistical equilibrium level for the CAPE ratio?
Will the CAPE ratio stabilize here, prompting the resumption of the long-term uptrend and the continuation of the May 2013 structural bull trend in SPX?
Or will the CAPE ratio collapse below the regression line, triggering a sharper decline toward the bottom of its structural uptrend channel (green line at 16.5-17)?
Will SPX earnings return toward fair valuations as QT replaces QE, higher interest rates replace lower interest rates, geopolitical tension replaces detente, high inflation replaces disinflation, and recession replaces economic growth?