What is the CAPE ratio? The highest reading since 1929 sounds extreme but what does it mean for markets?
- The CAPE ratio has reached its highest since 1929 with exception of the dot-com bubble
- CAPE stands for Cyclically-adjusted Price-to-Earnings ratio and it was invented by Robert Shiller (also of Case-Shiller index fame)
- It’s a way to measure valuations when adjusted for the business cycle.
- What’s the difference between CAPE and the regular P/E ratio ?
- How to calculate the CAPE ratio for stock indices and individual shares
- For value investors, the current level of CAPE for the S&P 500 is a signal to wait - but for growth and momentum traders, there is still opportunity
As noted above, the CAPE now at the same valuation as the peak of the stock market in 1929 before the crash. The only time it has been higher is the dot-com bubble of the late nineties.
What is the CAPE ratio?
CAPE stands for Cyclically-adjusted Price-to-Earnings ratio. It’s a way to measure valuations when adjusted for the business cycle. It was popularised by Robert Shiller of Yale University who also co-invented the Case-Shiller index for House prices.
The CAPE ratio is a valuation metric that compares the price of a stock or index with its real earnings per share over a 10-year period. It is a variant on the price-earnings (P/E) ratio. The ‘cyclical-adjusted’ or C-A part of CAPE is an attempt to smooth out the effects of inflation and the business cycle to get a truer reflection of valuation of the specific asset, stripping out what is going on in the business environment at that moment in time.
The idea is to measure a the durability of a company’s profitability under different business environments.
How to calculate CAPE
The CAPE ratio is calculated by dividing the stock price or index price by the average of the company’s or index’s earnings over a ten-year period and adjusting it for inflation.
What’s the difference between CAPE and PE?
CAPE contrasts with the traditional P/E ratio.
The PE ratio compares the stock price with its current earnings per share. Earnings per share is calculated by dividing annual earnings by the number of shares. In the case of an index, the P/E uses the index price and the accumulated EPS figures of all the stocks in the index.
While P/E is a much more widely used metric, one criticism of it might be that only using one year’s worth of earnings might not give a true reflection of the value of the company. Company’s have good and bad years after all.
How to use CAPE
A high CAPE shows markets are over-valuing the stock or index, while a low CAPE demonstrates markets are undervaluing them. The assumption behind the model is that a low CAPE should lead to higher future returns as the stock or index returns to or perhaps exceeds a fair valuation, while conversely a high CAPE implies lower returns.
There is of course some academic disagreement about the value of CAPE for forecasting. Critics point to the lagging data from over 10 years and changing accounting standards which make using earnings over a long period inaccurate.
What does the high CAPE mean for the S&P 500?
The interpretation will depend on your trading style. If you are a value investor, the highest CAPE since 1929 is another addition to a long catalogue of reasons why this ‘everything rally’ is tough going. There is little ‘value’ to be found when stock markets are near record highs and earnings have fallen dramatically in the deepest recession ever. Under these circumstances, the better option is to wait rather than seek value where it cannot be found.
However, if your trading style is shorter term and you are looking growth and momentum, this high CAPE ratio is a sign of a very strong market. Valuation metrics can remain ‘over valued’ for long stretches of time. AS we know well enough from 2020, strong (even excessive) bull markets offer lots of opportunity to benefit from rising prices. If all trades are placed with the knowledge that the market is overvalued, then suitable risk management techniques can be employed for when the top is finally in.