DEFINITION of 'CAPE Ratio'

The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. The ratio is generally applied to broad equity indices to assess whether the market is undervalued or overvalued. While the CAPE ratio is a popular and widely-followed measure, several leading industry practitioners have called into question its utility as a predictor of future stock market returns.

The CAPE ratio, an acronym for Cyclically Adjusted P/E (i.e. Price-Earnings) ratio, was popularized by Yale University professor Robert Shiller.

It is also known as the Shiller P/E ratio.

BREAKING DOWN 'CAPE Ratio'

A company’s profitability is determined to a significant extent by the economic cycle. During expansions, profits rise substantially as consumers spend with abandon, but during recessions, profits plunge and often turn into losses. While profit swings are much larger for companies in cyclical sectors – such as commodities and financials – than they are for firms in defensive sectors such as utilities and pharmaceuticals, few companies can maintain steadfast profitability in the face of a deep recession. Because volatility in per-share earnings also results in price-earnings (P/E) ratios that bounce around too much, Benjamin Graham and David Dodd recommended in their seminal 1934 book, Security Analysis, that for examining valuation ratios, one should use an average of earnings over preferably seven or ten years.

The Cyclically Adjusted Price-Earnings (CAPE) ratio initially came into the spotlight in December 1996, after Robert Shiller and John Campbell presented research to the Federal Reserve that suggested stock prices were running up much faster than earnings. In the winter of 1998, Shiller and Campbell published their groundbreaking article Valuation Ratios and the Long-Run Stock Market Outlook, in which they smoothed earnings for the S&P 500 by taking an average of real earnings over the past 10 years, going back to 1872.

This ratio was at a record 28 in January 1997, with the only other instance (at that time) of a comparably high ratio occurring in 1929. Shiller and Campbell asserted the ratio was predicting that the real value of the market would be 40% lower in ten years than it was at that time. That forecast proved to be remarkably prescient, as the market crash of 2008 contributed to the S&P 500 plunging 60% from October 2007 to March 2009.

The CAPE ratio for the S&P 500 climbed steadily in the second decade of this millennium as the economic recovery in the U.S. gathered momentum and stock prices reached record levels. As of October 2017, the CAPE ratio stood at 31.21, compared with its long-term average of 16.80. The fact that the ratio had previously only exceeded 30 in 1929 and 2000 triggered a raging debate about whether the elevated value of the ratio portends a major market correction.

Critics of the CAPE ratio contend that it is of little use because it is inherently backward-looking, rather than forward-looking. Another issue is that it uses GAAP (generally accepted accounting principles) earnings, which have undergone marked changes in recent years. In June 2016, Jeremy Siegel of the Wharton School published a paper in which he said that forecasts of future equity returns using the CAPE ratio may be overly pessimistic because of changes in the way GAAP earnings are calculated. Siegel said that using consistent earnings data such as operating earnings or NIPA (national income and product account) after-tax corporate profits, rather than GAAP earnings, improves the forecasting ability of the CAPE model and forecasts higher U.S. equity returns. 

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