Cyclically Adjusted P/E Ratio

• The Bottom Line: The CAPE ratio smooths out the volatile boom-and-bust cycles of the economy to give you a more reliable, long-term view of whether the stock market is cheap or expensive.
• Key Takeaways:
• What it is: A valuation metric that compares the current market price to the average of the last 10 years of inflation-adjusted corporate earnings.
• Why it matters: It prevents you from being misled by a single great year (making a stock look cheap) or a single terrible year (making it look expensive), helping you assess the market's true valuation. It's a cornerstone of market_valuation.
• How to use it: Compare the current CAPE ratio to its long-term historical average to gauge if the market is overvalued, undervalued, or fairly priced, thus informing your margin_of_safety.

Imagine you're a scout for a baseball team, and you need to assess a star player. Would you judge his entire career based on one spectacular, home-run-filled game? Of course not. That one game could be a fluke. You'd also be foolish to write him off after one terrible game where he struck out every time. A smart scout would look at his batting average over several full seasons to get a true picture of his skill. The standard price_to_earnings_ratio, or P/E ratio, is like judging the player on that single game. It takes the current stock price and divides it by the company's earnings from just the last 12 months. This can be wildly misleading. If the economy was booming, earnings might be temporarily inflated, making the market look cheaper than it really is. If the economy was in a deep recession, earnings might be temporarily crushed, making the market look terrifyingly expensive. The Cyclically Adjusted Price-to-Earnings Ratio (CAPE), also known as the Shiller P/E or P/E 10, is the seasoned scout's approach. Instead of looking at one year of earnings, it looks at the average of the last ten years of earnings, and it adjusts all those past earnings for inflation. Let's break that down:

• Cyclically Adjusted: The “cycle” refers to the business_cycle—the natural ebb and flow of the economy between periods of expansion (booms) and contraction (recessions). By averaging earnings over ten years, the CAPE ratio smooths out these peaks and valleys, giving you a normalized, more stable measure of a company's or the market's underlying earning power.
• Inflation-Adjusted: A dollar in 2014 was worth more than a dollar today. The CAPE ratio accounts for this by adjusting all ten years of past earnings into today's dollars. This ensures you are comparing apples to apples across a full decade.

So, in essence, the CAPE ratio asks a simple, powerful question: “How much are we paying today for a decade's worth of normalized, inflation-adjusted corporate profits?” It's a way to step back from the short-term market noise and see the bigger picture.

“The intelligent investor is a realist who sells to optimists and buys from pessimists.” - Benjamin Graham

The CAPE ratio is one of the most powerful tools a realist can use to identify when the market is dominated by irrational optimism or excessive pessimism.

For a value investor, the CAPE ratio isn't just another financial metric; it's a philosophical compass. The entire discipline of value_investing, as taught by Benjamin Graham and Warren Buffett, is built on a foundation of long-term thinking, emotional discipline, and a relentless focus on buying assets for less than their intrinsic_value. The CAPE ratio supports every one of these pillars.

• It Enforces a Long-Term Perspective: The stock market is often obsessed with the next quarter's earnings report. This short-term focus creates volatility and emotional decision-making. The CAPE ratio, with its 10-year window, forces you to zoom out. It encourages you to think like a business owner analyzing a decade of performance, not a speculator gambling on next week's price action. It helps you ignore the market's manic-depressive mood swings.
• It's a “Fear and Greed” Gauge: The CAPE ratio is an excellent barometer for market sentiment. When the CAPE is at historical highs (like during the dot-com bubble of the late 1990s), it's a clear signal that greed and euphoria are rampant. Prices have become detached from their underlying, long-term earnings power. Conversely, when the CAPE is at historical lows (like in the depths of the 2008 financial crisis), it signals that fear and pessimism have taken over. These are precisely the moments a value investor lives for.
• It Defines Your Margin of Safety: The central concept in value investing is the margin_of_safety. You calculate what a business is worth and then insist on buying it for a significant discount. The CAPE ratio helps you apply this concept to the market as a whole. A very high CAPE tells you that the market's margin of safety is thin or nonexistent. Any bad news could cause a significant drop. A low CAPE suggests a wide margin of safety is available; the market has already priced in a lot of bad news, providing a cushion against further downside.
• It Helps You Avoid Value Traps: A “value trap” is a stock that looks cheap based on its traditional P/E ratio but is actually in terminal decline or at the peak of a cyclical boom. Imagine an oil company in a year when oil prices are at an all-time high. Its earnings will be massive, and its P/E ratio might look very low. The CAPE ratio would cut through this illusion by averaging in the earnings from years when oil prices were normal or low, revealing a much higher and more realistic valuation.

While you can easily find the current CAPE ratio for the S&P 500 online ¹⁾, understanding the mechanics is crucial for any serious investor.

The formula itself is straightforward: CAPE Ratio = Real Market Price / 10-Year Average of Real Earnings per Share Let's unpack the steps to calculate it for a broad market index like the S&P 500:

1. Step 1: Gather the Data. You need two sets of data for the past ten years: the monthly closing price of the index and the reported earnings per share (EPS) for the index. You also need a historical inflation measure, like the Consumer Price Index (CPI).
2. Step 2: Adjust for Inflation. Convert all historical prices and earnings into today's dollars. For example, to adjust 2015 earnings to today's value, you would multiply the 2015 earnings figure by the ratio of today's CPI to the 2015 CPI. This is called calculating the “real” price and “real” earnings.
3. Step 3: Average the Earnings. Once you have ten years of real earnings, add them all up and divide by ten. This gives you the 10-year average of real earnings, the denominator of the formula.
4. Step 4: Divide. Take the current real market price (Step 2) and divide it by the 10-year average of real earnings (Step 3). The result is the CAPE ratio.

An absolute CAPE number is meaningless in isolation. Its power comes from comparing it to its own history. For the U.S. stock market (S&P 500), the long-term historical average CAPE is around 17.

• A High CAPE Ratio (e.g., above 25): This suggests the market is expensive relative to its history. It indicates that investors are optimistic and are willing to pay a high price for a dollar of normalized earnings. A high CAPE does not predict an imminent crash, but it does strongly correlate with lower-than-average returns over the following 10-15 years. When the CAPE is high, your expectations for future growth should be tempered.
• A Low CAPE Ratio (e.g., below 15): This suggests the market is cheap relative to its history. It indicates pessimism and fear are prevalent. A low CAPE doesn't mean the market can't go lower in the short term, but it has historically been a strong indicator of higher-than-average returns over the following decade. These are the periods when patient, long-term investors can find the best bargains.
• A “Normal” CAPE Ratio (e.g., 15-20): This suggests the market is somewhere in the range of fair value. Future returns are more likely to be in line with long-term historical averages.

The key is to think of the CAPE ratio not as a timing tool, but as a tool for setting expectations and managing risk.

Let's travel back in time to two crucial moments in market history to see the CAPE ratio in action. Scenario 1: The Peak of the Dot-Com Bubble (Late 1999)

• The Market Mood: Euphoria. The internet was changing the world, and tech stocks were soaring to unimaginable heights. Commentators declared a “New Economy” where old valuation rules no longer applied.
• The Traditional P/E: The standard trailing P/E ratio for the S&P 500 was hovering around 30. This was high, but with corporate earnings growing rapidly, many justified it.
• The CAPE Ratio's Verdict: A value investor calculating the CAPE ratio would have seen a terrifying picture. After averaging the inflation-adjusted earnings from the calmer years of the early and mid-1990s, the CAPE ratio for the S&P 500 soared to an all-time high of over 44.
• The Value Investor's Insight: The CAPE of 44 was more than double the historical average. It was a screaming siren that the market was priced for a level of perfection that was utterly unsustainable. It showed that current prices were completely disconnected from a decade of actual, underlying business performance. A value investor using this tool would have concluded that the margin of safety was zero and that the risk of a catastrophic decline was immense. They would have been selling, not buying.

Scenario 2: The Depths of the Great Financial Crisis (March 2009)

• The Market Mood: Abject terror. Global banks were collapsing, unemployment was skyrocketing, and many believed a second Great Depression was imminent.
• The Traditional P/E: This metric became almost useless. Corporate earnings had collapsed so severely in 2008 that the “E” in the P/E ratio was close to zero, sending the P/E ratio to over 100 for the S&P 500! Based on this, the market looked astronomically expensive.
• The CAPE Ratio's Verdict: The CAPE ratio told a completely different story. It averaged in the healthy earnings from the boom years of the early and mid-2000s along with the terrible earnings of 2008. This smoothing effect gave a more normalized picture of earning power. In March 2009, the CAPE ratio fell to around 13.
• The Value Investor's Insight: While the news was terrifying and the standard P/E was broken, the CAPE showed that the market was cheaper than it had been in over two decades. It was a signal that extreme pessimism had created a generational buying opportunity. An investor guided by the CAPE would have seen a massive margin of safety and would have been buying when others were panic-selling.

Like any tool, the CAPE ratio is brilliant when used correctly but can be misleading if its limitations aren't understood.

• Smooths Out Volatility: Its greatest strength is filtering out the noise of the business cycle and one-off corporate events (like huge write-downs), providing a more stable and meaningful valuation picture.
• Promotes Long-Term Thinking: It inherently forces an investor to adopt a decade-long view, which is the cornerstone of the value_investing philosophy and a powerful antidote to short-term speculation.
• Excellent Predictor of Long-Term Returns: While it can't predict next year's market, the starting CAPE ratio has historically been one of the most reliable predictors of average annual returns over the subsequent 10 to 15 years. ²⁾.

• It Is Not a Market-Timing Tool: This is the most common mistake. Seeing a high CAPE and selling everything, or seeing a low CAPE and going all-in, is a misuse of the metric. High valuations can persist for years, and low valuations can get even lower. It's a valuation gauge, not a short-term trading signal.
• Accounting Rules Change: The way companies report “earnings” under Generally Accepted Accounting Principles (GAAP) has evolved. This can make comparing the CAPE of 2024 to the CAPE of 1954 a slightly imperfect exercise.
• Economic Structures Can Evolve: Critics argue that changes in the economy—such as lower prevailing interest rates, changes in corporate payout policies (buybacks vs. dividends), and globalization—may justify a higher average CAPE than in the past. While value investors are rightly skeptical of “this time is different” arguments, it's a structural point worth considering.
• Less Effective for Single Stocks: The CAPE is most powerful for analyzing a broad market index. A single company can undergo such a radical transformation in ten years (e.g., a tech company pivoting to a new product) that its earnings from a decade ago may be completely irrelevant to its future prospects.

• price_to_earnings_ratio
• margin_of_safety
• intrinsic_value
• market_valuation
• business_cycle
• inflation
• mean_reversion