Cyclically Adjusted Price-to-Earnings Ratio
The cyclically adjusted price to earnings (CAPE) ratio has risen to considerable prominence in recent years. It is typically allied with the argument that equities in general, and the American market in particular, are expensive. It is a weapon of choice for bears.
CAPE is a simple concept, but misnamed. To be more accurate, it would be the ‘price to inflation-adjusted average earnings ratio’, but that does not make nearly such a nice acronym. The concept was originally articulated by Graham and Dodd back in 1934, but has been popularized by the multifarious and Nobel Prize winning Robert Shiller. So much so that it is now frequently just called the ‘Shiller p/e’. Its purpose is to try to improve on the basic p/e ratio as a ready-reckoner to show how expensive an asset is. It can be used for any equity or equity index. In this article let’s just stick with the S&P 500 Index.
Company earnings, so the theory goes, tend to ebb and flow with the economy and thus mean little in isolation. They become more meaningful if you can iron out these fluctuations by taking an average. The idea is to be able to ‘look through the cycle’. One problem with this is that no-one has much of an idea of the length of an ‘economic cycle’, so it is easy and convenient to take it as being 10 years. To calculate the CAPE, you start by taking the total earnings made by the market during each discrete year. This then needs to be adjusted by inflation into present day prices so they are comparable. Having obtained the inflation-adjusted earnings for each of the past 10 years, we can then average these and divide the current level of the index by the answer. Hey presto, we have a Shiller p/e.
The process has a lot going for it. By using rolling 10 year periods it is consistent and relatively immune to short-term noise. It therefore looks as if the CAPE should be a big improvement over the single year and more volatile p/e ratio. But it is what it is; it is a smoothed p/e ratio and not a buy or sell indicator. It tells us where one valuation measure stands relative to its own history, not whether the market is going to go up or down.
Useful as the CAPE is, it has its drawbacks. First amongst equals is that it is backwards looking, it does not tell us about what analysts expect to happen in the future. Second, it can take a very long time to come back to its long term average once it has gone AWOL. Up to twenty years in fact. So although the bears’ argument runs that American equities are currently expensive because the Shiller p/e is 60% or so above its long term average and what goes up must come down, it may take a decade or more for this to happen. Or it may happen much quicker. Or it may never happen.
CAPE is a very blunt short-term tool. What it does tell us though is that to buy American equity is to bet that what is expensive will become even more so. And that is an important piece of information to know.