Cyclically adjusted price-to-earnings (CAPE) ratio, also known as the Shiller PE ratio, is a valuation metric used by investors to assess whether a stock or the broader market is overvalued or undervalued. Unlike the traditional price-to-earnings (PE) ratio, which looks at a company’s current earnings, the CAPE ratio averages earnings over a 10-year period, adjusted for inflation. This approach provides a more stable and long-term view of market valuation by smoothing out the effects of economic cycles. You can use the CAPE ratio to gauge the potential for future returns or to compare current market valuations against historical averages.
A financial advisor can help you assess market trends and make informed investment decisions.
What Is the CAPE Ratio?
The CAPE ratio is calculated by dividing the current price of a stock or index by the average inflation-adjusted earnings over the previous 10 years. It is also sometimes referred to as the Shiller PE ratio. This calculation is designed to smooth out fluctuations caused by economic cycles, allowing for a clearer view of long-term earnings trends. The CAPE ratio formula is as follows:
CAPE Ratio = Current Price / Average Inflation-Adjusted Earnings (Last 10 Years)
For example, if a stock is trading at $200 and the average inflation-adjusted earnings over the past 10 years is $10, the CAPE ratio would be calculated as:
CAPE Ratio = $200 / $10 = 20
A CAPE ratio of 20 indicates that investors are willing to pay $20 for every dollar of inflation-adjusted earnings. A higher CAPE ratio suggests that the market or a stock may be overvalued, while a lower CAPE ratio indicates undervaluation. This can help investors assess whether the current market is likely to generate strong returns or if it is in a potentially overvalued state.
How to Use the CAPE Ratio
The CAPE rate’s utility lies in the way it provides insight into the relative valuation of a market or stock. By comparing the current CAPE ratio to historical averages, you can determine whether the market is overvalued or undervalued.
For example, if the CAPE ratio is significantly higher than its long-term average, it may indicate that the market is overvalued and that returns may be lower in the future. But a CAPE ratio well below the average suggests undervaluation, which could signal a buying opportunity.
Investors often use the CAPE ratio to make broad investment decisions, such as adjusting the proportion of stocks in their portfolios. For example, if the CAPE ratio is high, an investor might reduce their equity exposure and allocate more to bonds or other safer assets. If the CAPE ratio is low, the investor may decide to increase their exposure to equities in anticipation of higher future returns.
While the CAPE ratio is not a short-term timing tool, it offers valuable guidance for those with a long-term perspective, and can help you align your portfolio with prevailing market conditions.
Historical Performance
The CAPE ratio was popularized by economist Robert Shiller, who used it to analyze historical market cycles and to predict potential future returns based on current valuations. Historically, the CAPE ratio has shown a strong correlation with long-term stock market returns. In general, when the CAPE ratio is high, future returns tend to be lower, while periods of low CAPE ratios have often preceded higher returns.
For example, during the dot-com bubble in the late 1990s, the CAPE ratio reached historically high levels, indicating an overvalued market. The subsequent market correction in the early 2000s validated the CAPE ratio’s warning signal, as stock prices declined sharply.
Conversely, in the aftermath of the 2008 financial crisis, the CAPE ratio dropped to low levels, signaling undervaluation. Investors who entered the market during this period benefited from strong gains in the following years. In recent years, domestic stock market CAPE ratio values have clustered around the 30 level, ranging from the mid-20s to the high 30s.
Comparison Across Different Markets
The CAPE ratio can be applied across different markets to compare relative valuations. While it was initially developed for the U.S. stock market, investors have expanded its use to assess other global markets.
For example, by examining the CAPE ratios of emerging markets versus developed markets, investors can determine which regions may offer more attractive valuations. Emerging markets often have lower CAPE ratios due to higher perceived risks and growth potential, while developed markets, with more established economies, tend to have higher CAPE ratios.
When comparing CAPE ratios across countries or regions, investors should consider economic and structural differences, as these factors can impact long-term earnings stability and growth potential. Some markets may have historically higher or lower CAPE ratios based on local economic conditions, making it essential for investors to use the CAPE ratio alongside other financial metrics and regional insights.
Frequently Asked Questions
What Is a Good CAPE Ratio?
There is no definitive “good” CAPE ratio, as it varies by market and economic conditions. However, a CAPE ratio significantly above its historical average may indicate overvaluation, while a ratio below the average could suggest undervaluation.
How Are CAPE and Traditional Price-Earnings Ratios Different?
The CAPE ratio uses a 10-year average of inflation-adjusted earnings, which smooths out cyclical fluctuations. In contrast, the traditional price-earnings (P/E) ratio only considers current earnings, making it more susceptible to short-term volatility.
Can the CAPE Ratio Predict Market Crashes?
The CAPE ratio is not a precise predictor of market crashes, but high CAPE ratios have historically preceded periods of lower returns. While it signals potential overvaluation, it does not provide specific timing for market corrections.
Is the CAPE Ratio Suitable for Short-Term Investments?
No, the CAPE ratio is more appropriate for long-term investment decisions, as it reflects the market’s valuation over a 10-year period. Short-term investors may benefit from using other financial metrics that focus on current market conditions.
Bottom Line
The CAPE ratio, or Shiller PE ratio, is a tool you can use to gain a long-term view of market valuation. By evaluating the CAPE ratio, you can assess whether a market or stock is overvalued or undervalued relative to historical averages. While not a short-term market predictor, the CAPE ratio provides essential insights into potential future returns and can guide adjustments to a portfolio according to prevailing market conditions.
Tips for Investing
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