Cyclically Adjusted Price Earnings Ratio (CAPE)
Cyclically Adjusted P/E: Popularised by Robert Shiller at the end of the 1990’s, this metric (known by the acronym CAPE), is an attempt smooth out the cyclical fluctuations in corporate profits that can make assessment of a traditional P/E ratio difficult to employ.
It uses the real (i.e. inflation -adjusted) EPS over a 10-year period to get a better understanding of a markets’ valuation- it is much less frequently used in analysis of an individual asset.
The formula is:
Market price/10-year average of inflation adjusted EPS = CAPE (or Shiller) ratio.
From this, an attempt at forecasting likely future market returns is made.
The use of 10 years’ worth of earnings data is an attempt to adjust for the effects on corporate profitability of the normal business cycle.
One years’ earnings cannot be a sufficient statistic to evaluate a share’s value, as it does not take into account the peaks and troughs of a firm’s earnings power.
Using CAPE Trading
Shiller’s research using 130 years of back-tested data suggested that S&P500 returns over the following 20 years were inversely related to the CAPE ratio at any given point (i.e. the higher the CAPE, the lower the future returns and vice versa).
Over more recent years, however its predictive ability appears to have declined.
Since the 1990’s the US markets for example have continued to generate strong returns for investors despite the fact that, according to Shiller himself, US markets have become increasingly expensive, making his predictions look overly pessimistic.
In addition, the ratio itself exhibits a high degree of variation, as do the economies of the markets under examination, thus making it less useful in attempting to predict market tops and bottoms.
It does not take into account the level of risk-free interest rates, which have been under downward pressure for the last 10 years or so.
It also takes no account of other changes that have occurred in the last 10 years, with regard to accounting practises, which include the more prevalent use of non-GAAP earnings and the treatment of intangible assets on a firm’s balance sheet, which have conspired to change the makeup of corporate profitability in ways which the CAPE cannot account for.
Although it is a good indication of whether or not a market is fairly valued, it may not alone be a good way of judging market valuations.
It is unclear whether or not 10 years is a long enough time to simulate the length of a business cycle and since the underlying assumption is one of mean reversion, which (as the 10-year period is amended every year with the data from 10 years ago dropping out of the formula), implies that valuation is somewhat of a moving target.
It is better used in conjunction with other indicators, such that a stronger signal (buy or sell) is generated if they all agree.