Reading the CAPE Ratio for Booms, Busts, and Bubbles

November 3, 2015 — 12:42 PM EST

The prospect of a low-returns era is real. Given the current investment climate, some experts, such as legendary investor Bill Gross (cofounder of Pacific Investment Management (PIMCO) and former manager of the world's largest bond fund), have even said that now is the time to invest in cash and short-term bonds (despite their uninspiring returns) rather than financial instruments, such as pension funds. Several prominent hedge fund managers are citing the cyclically adjusted price-to-earnings ratio, also known as the CAPE ratio, to warn about an impending downturn and low-returns era future. 

But what is the CAPE ratio, and is it an accurate predictor of the market's future?

The CAPE Ratio and an Argument for Low Returns 

Developed by Yale economics professor Robert Shiller, the CAPE ratio is also called the Shiller price-to-earnings ratio. It smooths fluctuations in market price-to-earnings ratios that are really a result of boom and bust economic cycles. It is calculated by normalizing irrational valuations generated during times of economic booms and busts. For example, companies tend to have higher earnings during an economic boom. In turn, this inflates their share price and the market's overall value. The result is a low price-to-earnings ratio, which is not an accurate reflection of the market's value. Similarly, stock earnings (and overall market value) tend to go down during a slowdown in the general economy. The result is an extremely high price-to-earnings ratio, another incorrect indicator of market dynamics. 

The CAPE ratio adjusts for business cycles and uses consumer price index (CPI) values to adjust for inflationary pressure on earnings. If the CAPE ratio trends high, then the market is considered to be in a boom period. The average CAPE ratio for the period between 1881 and 2015 in the United States was 17. The current CAPE ratio is 25. In a recent New York Times article, Professor Shiller wrote that the only years with a higher CAPE ratio were 1929, 2000 and 2007. Chillingly, all three years were economic boom peaks that subsequently gave way to periods of depression or recession. 

Cofounder of AQR Capital Management and economic commentator Cliff Asness is one the leading voices predicting a coming low-return era. He bases his prediction, in part, on the CAPE ratio. According to Asness, bonds and stocks are currently expensive based on a CAPE ratio of 25.18. He outlines two possible scenarios: a drop in prices followed an improvement in returns or a prolonged stagnation in the form of low returns and high prices. The second scenario would provide investors with a return of 3% on a traditional portfolio allocation of 60/40 in stocks and bonds. 

Is the CAPE Ratio Enough to Predict Low Returns? 

While it is true that the CAPE ratio reflects market vagaries during economic booms and downturns, there have been arguments against the time frame against which it is measured. 

For example, Jeremy Grantham, cofounder of asset management firm Grantham Mayo van Otterloo (with $118 billion under management) and authority on predicting bubbles, says the comparisons for the CAPE ratio's current value should be made from April 1987. That's when Alan Greenspan became chairman of the Federal Reserve and started a low-interest rate era. Back then, the CAPE ratio was 24. By that measure, the ratio's current measure is not expensive. Even CAPE ratio creator Robert Shiller is hesitant to predict the puck's direction. In a September 2015 interview, he said that he was wary about advising people to pull of the market based on the ratio number. But, Shiller maintains that the CAPE ratio serves as a warning signal and that there was the risk of a "significant market decline.” 

In a 2013 paper, Cliff Asness wrote “if you don't lower your expectations when Shiller P/E's [CAPE ratio] are high without a good reason – and in my view the critics have not provided a good reason this time around – I think you are a making a mistake.” The last two years have proved Asness right as global growth numbers are weak and anemic. Fundamental macroeconomic indicators seem to point to an era of low returns. Broad economic indices for global markets are edging downwards. The International Monetary Fund recently revised its projections for global growth for next year due to a downturn in the Chinese economy. In contrast, the CAPE ratio has remained stubbornly high.  

Despite his reservations about the current market, investor Jeremy Grantham predicts a difficult time ahead for large cap stocks, which are “likely to under perform for the next seven years.” Given weakening demand across the world, this prediction may very well turn out to be true. 

The Bottom Line     

The CAPE ratio is a technical indicator and reflects the fundamentals of a shaky global economy. As the economy improves, so will the ratio.