Cyclically Adjusted Price-to-Earnings Ratio (CAPE Ratio)

The Cyclically Adjusted Price-to-Earnings Ratio (also known as the 'CAPE Ratio' or 'Shiller P/E') is a valuation metric used to assess whether a stock, an index, or the entire stock market is overvalued or undervalued. Developed and popularized by Yale University professor and Nobel laureate Robert Shiller, the CAPE ratio is a more robust version of the standard P/E ratio. It’s calculated by taking the current price of a stock or index and dividing it by the average of its inflation-adjusted earnings over the past ten years. This ten-year smoothing is the magic ingredient; it irons out the wild swings in corporate profits caused by the natural ebbs and flows of the business cycle, like recessions and boom times. By doing so, the CAPE ratio provides a clearer, more stable picture of a company's or market's long-term earning power, helping investors avoid the trap of being overly optimistic during a boom or excessively pessimistic during a bust.

Imagine you're judging a baker based on a single cake. If it was a spectacular wedding cake, you might think they're a genius. If it was a burnt muffin, you might write them off completely. Neither judgment is fair. The standard P/E ratio is a bit like that; it judges the market based on just one year of earnings. If that year was at the peak of an economic boom, earnings are inflated, making the market look deceptively cheap. Conversely, if it was at the bottom of a recession, earnings are depressed, making the market look frighteningly expensive. The CAPE ratio is like tasting the baker's creations over an entire month. By averaging earnings over ten years, it accounts for both the good and the bad times, giving you a far more reliable sense of the market's true valuation.

The CAPE ratio is not a crystal ball for predicting next week's market movements. Instead, it’s a powerful tool for gauging potential long-term returns, typically over the next decade or two.

A CAPE ratio that is significantly above its long-term historical average suggests the market may be overvalued. Think of it as a market high on sugar; the euphoria can’t last forever. Historically, high starting CAPE ratios have been associated with lower-than-average returns over the following 10 to 20 years. This doesn't mean a crash is imminent, but it does suggest that future growth might be more of a gentle uphill stroll than a rocket launch. It's a signal for the prudent investor to be more cautious and selective.

Conversely, a CAPE ratio that is well below its historical average suggests the market may be undervalued. This often happens when pessimism is widespread, such as during a market panic or a prolonged recession. For the patient investor, a low CAPE ratio can be a green light. Historically, low starting CAPE ratios have been followed by higher-than-average returns over the subsequent 10 to 20 years. It signals that there might be bargains to be had for those willing to buy when others are fearful.

The CAPE ratio is a natural fit for the value investing philosophy. The legendary Benjamin Graham, Warren Buffett's mentor, advocated for a similar approach, urging investors to use a multi-year average of earnings to value businesses. The CAPE ratio formalizes this wisdom. For a value investor, the CAPE ratio acts as a market “thermometer.”

• When the CAPE is high: The market is “hot.” A value investor might become more defensive, holding more cash, focusing on only the most exceptional bargains, and avoiding speculative excess.
• When the CAPE is low: The market is “cold.” This is the time for a value investor to be greedy when others are fearful. It can be an opportune moment to deploy capital and purchase good businesses at discounted prices.

It helps investors stick to the core tenet of value investing: buy assets for significantly less than their intrinsic worth and hold them for the long term.

While powerful, the CAPE ratio isn't perfect. Wise investors should be aware of its potential shortcomings:

• Accounting Changes: Accounting standards, such as GAAP (Generally Accepted Accounting Principles), have changed over the decades. Modern rules tend to be more conservative, which may artificially depress reported earnings compared to past eras, potentially making today's CAPE ratios look higher than they really are on a like-for-like basis.
• Interest Rates: The CAPE formula doesn't account for the level of interest rates. In a low-interest-rate environment, stocks become relatively more attractive compared to bonds, which could justify a structurally higher CAPE ratio.
• Composition of the Market: The makeup of the market changes. For example, the modern market is less capital-intensive and more dominated by technology and service companies than the industrial-heavy market of the early 20th century. This structural shift could also mean historical averages are less relevant.
• Not a Timing Tool: It's worth repeating: the CAPE is terrible at predicting short-term market crashes or rallies. Markets can remain “overvalued” according to CAPE for many years, and “undervalued” markets can continue to fall.

Ultimately, the CAPE ratio is one tool in a well-stocked investor's toolkit—not the only one. It provides invaluable long-term context but should be used alongside other forms of analysis.