The CAPE Ratio
A metric from someone way smarter than me
There is a high correlation between intelligence and winning Nobel prizes. It makes sense then, that if someone who has won a Nobel prize publishes a very well-known metric, it is worth paying attention to. That’s where the Cyclically Adjusted Price-to-Earnings (“CAPE”) Ratio comes in, which Robert J. Shiller tracks on a monthly basis:
This metric is a bit more complicated than just dividing a stock index by GDP. Instead, the stock index (S&P 500 in this case) is divided by earnings, which is basically the profit being made by all the companies in the index.
The cyclical part comes from averaging the last ten years of earnings, which removes a lot of the noise that comes from volatile corporate profits through a given business cycle. So, you take whatever the stock index is at the time and divide it by the moving ten-year average of cyclically adjusted earnings and you have the CAPE ratio! This version here is also adjusted for inflation to make it even more comparable between periods across the 140 year time frame.
This is one of the best valuation metrics for stocks. There is clear correlation between the CAPE ratio level and future stock returns over the next twenty years. When it has peaked in the past, like at the height of the 1929 bubble or the tech bubble, bad times have followed in the coming years for stocks.
Currently, the ratio is quite elevated. That doesn’t mean stocks will crash tomorrow but it is something to consider when investing. The ratio suggests that returns over the next twenty or so years will be lower than they would be otherwise.
That being said, just because returns may be lower in a relative sense, doesn’t mean that stocks are a bad investment option. As I’ve mentioned in the past, don’t worry so much about trying to time the market based on a few ratios. A lot of gains have been lost by individuals who were afraid to jump in. Sometimes waiting can be more detrimental to an investor than temporary dips.
Enjoy the article? If you haven’t already, subscribe for free below and never miss a post. No spam. Cancel whenever!
Related content:
Golden Crosses (and Death Crosses!)
Valuation With Moving Averages?
What does overvalued even mean?
S&P 500 / Gross Domestic Product for the World
Gross Domestic Product for the World
S&P 500 / Gross Domestic Product