10,000-Year Perspective on Cyclically Adjusted Price Earnings (CAPE)

Understanding CAPE

Cyclically Adjusted Price Earnings (CAPE), also known as the Shiller PE, is a valuation metric that attempts to smooth out the volatility of traditional price-to-earnings (P/E) ratios by using a 10-year moving average of adjusted earnings. Introduced by Yale economist Robert Shiller, CAPE is designed to account for the cyclicality of earnings, providing a more comprehensive representation of a company's valuation.

CAPE's Value in Investment Decisions

CAPE is widely used by investors and financial analysts to assess the overall valuation of the stock market and to identify potential over or undervaluation. According to research, CAPE has a strong correlation with future market returns over the long term.

"CAPE is the best single measure of where valuations stand at any given moment." - Robert Shiller

CAPE and Historical Market Returns

The following table shows the average CAPE ratio and the corresponding annualized stock market returns for different time periods:

As the CAPE ratio increases, the expected future returns tend to decrease.

Using CAPE in Practice

To evaluate the stock market using CAPE:

1. Calculate the current CAPE ratio for the market index (e.g., S&P 500).
2. Compare the current ratio to historical averages and past CAPE levels.
3. Determine if the market is overvalued (CAPE above the historical average) or undervalued (CAPE below the historical average).

Common Mistakes to Avoid

• Ignoring the Long-Term Context: CAPE is a long-term valuation metric, and investors should avoid making investment decisions based on short-term CAPE fluctuations.
• Overemphasizing the CAPE Ratio: While CAPE is a valuable tool, it should not be used as the sole indicator for investment decisions. Consider other factors such as economic growth, interest rates, and market sentiment.
• Timing the Market: CAPE does not provide precise entry or exit points for the stock market. Investors should use CAPE as a general valuation guide rather than trying to "time the market."

FAQs

1. What is the "fair value" CAPE ratio? There is no definitive fair value, but historically, a CAPE ratio of 14-16 has been associated with long-term average returns.
2. How often should I check CAPE? Regularly monitoring CAPE is recommended, especially during periods of market volatility or significant economic changes.
3. Can CAPE be used for individual stocks? While CAPE is primarily used for the overall stock market, it can also be applied to individual stocks to assess their relative valuation.
4. What's the "new word" for new applications of CAPE? "CAPEvolutionary" - describes innovative applications of CAPE, such as using it to predict economic recessions or develop alternative investment strategies.

Table of Notable CAPE Levels in History

Table of CAPE and Annualized Stock Market Returns for Specific Years

Table of CAPE and Expected Future Market Returns

Table of CAPE and Historical Bear Markets