Cyclically Adjusted Price Earnings (CAPE): A Comprehensive Guide

Introduction

In investing, one of the key metrics used to gauge the value of a stock or market is the cyclically adjusted price earnings ratio (CAPE). Developed by Yale economist Robert Shiller, CAPE aims to adjust for the fluctuations in earnings that occur over business cycles, providing a more comprehensive view of a company's or market's long-term valuation.

Calculation of CAPE

CAPE is calculated by dividing the current price of an index or stock by the average inflation-adjusted earnings over the past 10 years. This adjustment helps to smooth out earnings volatility, which can be influenced by economic factors that may not reflect the true underlying value of the asset.

Historical Perspective

Shiller's research has revealed that CAPE has exhibited a consistent correlation with subsequent market returns. Historically, higher CAPE ratios have tended to be associated with lower future returns, while lower CAPE ratios have implied potential for higher future returns.

Applications of CAPE

CAPE can be a valuable tool for investors seeking to make informed investment decisions. Some of its key applications include:

• Market Valuation Assessment: CAPE provides a long-term perspective on market valuations, helping investors identify potential over or undervaluation. High CAPE ratios may indicate a market that is overpriced and due for a correction, while low CAPE ratios may signal an opportunity for potential growth.
• Stock Selection: CAPE can aid in identifying individual stocks that are trading at fair or attractive valuations. By comparing a stock's CAPE to its historical average and industry peers, investors can assess its potential for outperformance.
• Timing Market Entry and Exit: CAPE can be used as a timing indicator for market entry and exit. When CAPE is low, investors may consider increasing their equity allocation, as it may suggest a potential for higher returns. Conversely, when CAPE is high, investors may consider reducing their exposure to equities to mitigate potential downside risks.

Benefits of Using CAPE

CAPE offers several benefits for investors:

• Long-Term Perspective: It provides a long-term view of valuations, smoothening out short-term earnings fluctuations.
• Historical Correlation: Historical data has shown a strong correlation between CAPE and subsequent market returns.
• Investment Decision Support: CAPE can assist investors in making informed decisions about market valuations, stock selection, and market timing.

Limitations of CAPE

While CAPE is a valuable tool, it is important to recognize its limitations:

• Historical Dependence: CAPE relies on historical data and may not fully account for future economic events or changes in market dynamics.
• Sensitivity to Interest Rates: CAPE can be influenced by interest rate fluctuations, which can impact inflation-adjusted earnings.
• Time Lag: CAPE may exhibit a time lag with market sentiment, meaning it may not always accurately predict future market returns.

Recent Market Trends

According to Shiller's CAPE website, the CAPE ratio for the S&P 500 as of August 31, 2023, is 28.61. This is significantly higher than its historical average of 16.82, indicating that the market is currently trading at a premium relative to its long-term earnings.

Expert Opinions

Experts in the investment industry have varying views on the significance of CAPE. Some believe it is a highly reliable indicator of market valuations, while others argue that it may not fully account for factors such as technological innovation and changing economic landscapes.

FAQs

Q: What is cyclically adjusted price earnings (CAPE)?
A: CAPE is a metric that adjusts the price of an index or stock by the average inflation-adjusted earnings over the past 10 years.

Q: How is CAPE calculated?
A: CAPE is calculated by dividing the current price by the average inflation-adjusted earnings over the past 10 years.

Q: What is the historical correlation of CAPE with market returns?
A: Historically, higher CAPE ratios have tended to be associated with lower future returns, while lower CAPE ratios have implied potential for higher future returns.

Q: What are the limitations of CAPE?
A: CAPE relies on historical data, may be influenced by interest rate fluctuations, and can exhibit a time lag with market sentiment.

Q: What is the current CAPE ratio for the S&P 500?
A: As of August 31, 2023, the CAPE ratio for the S&P 500 is 28.61.

Q: Is CAPE a reliable indicator of market valuations?
A: Experts have varying views on the reliability of CAPE, with some believing it is a highly useful indicator and others arguing that it may not fully account for all factors.

Q: How can CAPE be used in investment decision-making?
A: CAPE can be used to assess market valuations, identify undervalued stocks, and make investment timing decisions.

Q: Are there any other indicators similar to CAPE?
A: Yes, there are other indicators that attempt to adjust for business cycle fluctuations, such as the Shiller PE ratio and the Graham Number.

Conclusion

Cyclically adjusted price earnings (CAPE) is a valuable tool for investors seeking to gain a long-term perspective on market valuations and make informed investment decisions. While it has limitations, CAPE provides insights into the potential for future market returns and can be used in conjunction with other indicators to enhance investment strategies.