The Idea Behind the CAPE Ratio
The cyclically adjusted price-to-earnings ratio, more commonly called the CAPE ratio or Shiller P/E, is a tool that investors use to assess whether the stock market is running too hot or undervalued. Unlike a standard P/E ratio that only looks at current earnings, this measure smooths things out by taking the average of inflation-adjusted earnings over a 10-year period. It was brought into the spotlight by Yale economist Robert Shiller, whose research demonstrated how this long-term approach offers a clearer view of market valuation through cycles of boom and bust.
Why the CAPE Ratio Was Created
Markets move in cycles. During economic expansions, corporate earnings surge, while during downturns, they may fall dramatically—or even turn negative. Relying on short-term profits can therefore paint a misleading picture of a company’s or an index’s true value. To solve this, early thinkers like Benjamin Graham and David Dodd suggested averaging earnings across several years to iron out distortions. Shiller expanded on that idea by incorporating inflation adjustments and a longer time horizon. The result is a ratio that captures a more stable view of how expensive or cheap the market is relative to its earnings power.
How the CAPE Ratio Is Calculated
The math behind the CAPE ratio is straightforward. The current share price of a stock or index is divided by the average of its real earnings per share from the past 10 years, adjusted for inflation. This ensures that both good years and bad years are represented, offering balance. For example, if an index trades at a price of $2,000 and its average inflation-adjusted earnings per share over the last decade is $100, the CAPE ratio would be 20. This number is then compared against historical averages to determine whether the market is unusually high, low, or somewhere in between.
Reading the CAPE Ratio in Context
Numbers by themselves don’t mean much until compared with history. Over the long haul, the average CAPE ratio for the U.S. stock market has hovered around 16 to 17. When the ratio rises far above this level, it may suggest that stocks are expensive and future returns could be lower. Conversely, a number well below the average could indicate undervaluation, potentially pointing to higher future returns. This perspective doesn’t provide precise timing for market moves, but it can help shape long-term expectations.
Historical Significance of the CAPE Ratio
The CAPE ratio earned widespread recognition in the late 1990s when Robert Shiller, alongside John Campbell, showed that stock prices were climbing much faster than underlying earnings. In January 1997, the CAPE ratio hit 28, a level not seen since 1929. Shiller warned that valuations were unsustainable, and though markets continued to rise for a few years, the early 2000s dot-com bust and later the 2008 financial crisis validated his concerns. Investors who paid attention to this ratio saw its predictive power in highlighting overvaluation long before the crashes unfolded.
Modern Readings and Market Debates
In recent years, the CAPE ratio has again sparked debate. As of mid-2024, the ratio for the S&P 500 stood above 35, more than double its long-term average. Such a reading naturally raises alarms, since the ratio has historically only surpassed 30 twice before—in 1929 and in 2000—both times followed by significant market corrections. Some analysts argue that today’s elevated valuations reflect structural changes, such as ultra-low interest rates, the rise of technology companies, and new accounting standards. Others believe that the CAPE ratio is still signaling potential risks ahead.
Criticisms of the CAPE Ratio
Not everyone agrees that the CAPE ratio is the ultimate guide to market valuation. One common criticism is that it looks backward, averaging earnings that may no longer reflect current conditions. For instance, accounting practices under GAAP have evolved, making comparisons across decades more complicated. Jeremy Siegel of the Wharton School has argued that these accounting shifts make the CAPE ratio appear more pessimistic than it should be. He suggests that alternative earnings measures, such as operating earnings, may provide a better basis for valuation.
Where the CAPE Ratio Is Most Useful
Despite criticisms, many investors still use the CAPE ratio as a check on market sentiment. It is particularly valuable for those with long-term horizons, as it helps frame expectations for equity returns over a decade or more. Pension funds, institutional investors, and individual savers alike can use it to guide asset allocation decisions. While it may not forecast short-term swings, the ratio helps identify whether current valuations are aligned with or diverging from historical norms.
Applying the CAPE Ratio Beyond the U.S.
Although most discussions focus on the S&P 500, the CAPE ratio can also be applied to international markets. For example, investors may compare CAPE ratios across countries to spot relative bargains or risks. Emerging markets sometimes show lower ratios compared to developed economies, but that may also reflect higher inherent risks. Used thoughtfully, the CAPE ratio becomes a tool for global portfolio diversification and risk assessment.
Lessons From Market History
Looking back, the CAPE ratio has had moments of both success and controversy. Its warnings ahead of the Great Depression, the dot-com bubble, and the global financial crisis demonstrate its usefulness as a cautionary indicator. At the same time, the ratio has occasionally stayed elevated for years while markets continued to rise, reminding investors that no single measure should dictate investment decisions. It is most effective when paired with other indicators, such as interest rates, corporate debt levels, and economic growth trends.
The Bottom Line on the CAPE Ratio
The CAPE ratio offers investors a way to filter out the noise of short-term earnings swings and assess whether stocks are trading above or below historical norms. While it cannot time market corrections or predict exact returns, it serves as a valuable compass for understanding long-term valuation trends. Investors who grasp its insights gain a clearer picture of potential risks and rewards in the market. Still, it should be used alongside other analysis tools and an awareness of its limitations. In the end, the CAPE ratio’s true value lies in helping investors keep perspective when emotions and market narratives run high.
FAQs about the CAPE ratio
Who introduced the CAPE ratio?
Yale economist Robert Shiller popularized the CAPE ratio, building on earlier work by Benjamin Graham and David Dodd.
How is the CAPE ratio calculated?
It’s calculated by dividing a stock or index’s current price by its average real earnings per share over the past 10 years.
Why use 10 years of earnings instead of just one?
Using a decade smooths out the big swings caused by recessions and booms, giving a more balanced picture of market value.
What is considered a normal CAPE ratio?
Historically, the long-term average has been around 16 to 17. Numbers far above this suggest higher valuations and possible risks.
Has the CAPE ratio predicted market crashes?
Yes. It was unusually high before the Great Depression, the dot-com crash, and the 2008 financial crisis, each followed by major downturns.
Why do some critics doubt the CAPE ratio?
Critics argue it relies too heavily on past data and GAAP accounting rules, which have changed over time, making comparisons tricky.
Can the CAPE ratio stay high for a long time?
Yes. During periods like the late 1990s and recent years, the ratio stayed elevated while stock prices kept rising, showing it’s not a timing tool.
Is the CAPE ratio only used for U.S. markets?
No. It can also be applied globally, helping investors compare valuations between countries and spot opportunities.
What’s the biggest benefit of the CAPE ratio?
It helps long-term investors keep perspective by highlighting whether markets are stretched or cheap compared to history.