CAPE today: how predictable is the ratio?

Nobel Prize-winning economist Robert Shiller made a name for himself when he  predicted the dotcom bubble using his  now-famous CAPE ratio. CAPE is short for cyclically-adjusted price-earnings ratio. It’s calculated  by taking the S&P 500 and dividing it by the average of ten years worth of  earnings.  If the ratio is above the long-term average of around 16, the  stock market is considered expensive. Shiller has argued that the CAPE is remarkably good at predicting returns  over the period of several years.

As the stock market has drifted to all-time highs, prices have outpaced  earnings growth and the CAPE his risen to a notable 24 times. Some folks warn that that this means the odds  of a crash have risen significantly. Check it out:


cape chart

But Jefferies’ Sean Darby isn’t having this. “There are a number of reasons that investors should be careful relying solely on one valuation model to determine whether the equity market is under or  overvalued,” said Darby. In a new note to clients, he lays out a five-point takedown of the  CAPE-toting crash mongers. From his note (emphasis added):

  • Firstly, the S and P is a market cap weighted index and profits will  likely be skewed unequally relative to the value of the company.
  • Secondly, as we pointed out in [a previous note], a number of US companies have large cash holdings which if stripped out would lower the absolute  PE multiple.
  • Thirdly, all models are ‘mean reverting’. Valuations can remain high for  long periods of time but stocks can continue to rise. Based on the Shiller CAPE,  stocks were overvalued for over twenty years but the S&P 500 has doubled  since 2009 and it doubled between 2003 and 2007. The Shiller CAPE is based on two variables just like many other stock valuation models. Hence it  could be that profits are too low and that they should mean revert upwards. This  would make the CAPE appear cheap. Furthermore, the ten year profits  moving average included a significant compression profits in 2008-09.  Statistically this is an outlier. In addition, the S&P 500 is itself an  index that sees substantial changes to its constituents. The stocks that  produced earnings ten years ago may not necessarily be in the index today. The  CAPE does not compare like-for-like companies.
  • Fourthly, other measures of price to profits suggest that stocks are not necessarily expensive. We have preferred to use nationwide profits  as a gauge of the value subscribed to ‘all US economic profits’ irrespective of  where they are derived from. The price to national income suggests that stock  prices are too low compared to the profits generated by US corporates.
  • Lastly, all models have a ‘hindsight bias’ to them. The ‘average’ that is highlighted today will be different ten years hence and stocks  could appear expensive or cheap depending on future profits.

In a nutshell, CAPE doesn’t adjust skews, companies have tons of cash, stocks  don’t have to fall for CAPE to mean-revert, other measures of earnings are more  reasonable, and there’s hindsight bias. One thing that Darby left out is that the whole principle of CAPE could fall  apart. “Things can go for 200 years and then change,” warned  another CAPE expert. “I even worry about the 10-year P/E — even that  relationship could break down.”



Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.




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