Cyclically Adjusted Price To Earnings RatioEdit
The Cyclically Adjusted Price To Earnings Ratio, commonly referred to by its acronym CAPE, is a valuation gauge that seeks to put stock prices in a longer-term context. Developed by economist Robert Shiller and colleagues, CAPE takes the price level of a broad market index and divides it by a 10-year average of inflation-adjusted earnings per share. By smoothing earnings over a full business cycle, CAPE tries to strip out the noise created by cyclical ups and downs in profits, giving investors a sense of whether the market is priced to deliver normal, long-run returns.
Proponents of CAPE view it as a useful barometer for assessing market risk and capital allocation. Rather than reacting to one-year profit swings, investors can gauge whether prices embed optimistic or pessimistic assumptions about future earnings power. For that reason, CAPE is widely cited in financial commentary and in scholarly work on long-horizon returns. The metric is closely associated with the broader idea that asset prices should reflect fundamental earning capacity, while also acknowledging that markets are not perfectly efficient and that sentiment can persist for extended periods. In practice, CAPE is most often applied to the S&P 500 or other major market indexes, and it is frequently discussed alongside standard measures like the Price-to-earnings ratio and the impact of how earnings are defined.
Methodology
- Calculation framework: CAPE = P / E10y_real, where P is the price level of a broad market index (most commonly the S&P 500) and E10y_real is the 10-year average of real, inflation-adjusted earnings per share. The real earnings denominator is intended to reflect ongoing earning power rather than short-term accounting quirks. In practice, the earnings series is often based on reported GAAP profits, adjusted for inflation using a price index such as the CPI.
- Time horizon and smoothing: The 10-year window is meant to capture the typical span of a business cycle, reducing the influence of one-time events or cyclical peaks and troughs. This smoothing is central to why CAPE is marketed as a longer-horizon indicator rather than a tactical timing tool.
- Variants and refinements: There are several variants and refinements in use. Some practitioners discuss a version sometimes called CAPE 2.0 that attempts to adjust for changes in interest rates, payout trends, or other secular shifts. Readers may also encounter references to the broader family of cyclically adjusted measures that aim to improve upon single-year P/E analyses.
- Data and interpretation: Because CAPE relies on earnings data, its readings depend on how earnings are measured and inflation is handled. Analysts frequently note that revisions to earnings definitions, accounting rules, and the growing role of share repurchases can influence the level and interpretation of CAPE over time. See Earnings and Dividends for related concepts.
Interpretation and uses
- What the numbers imply: Historically, CAPE tends to wander around a long-run mean, with stretches above the mean associated with expectations of slower subsequent returns and stretches below the mean suggesting higher prospective returns. In common discussions, the long-run mean for CAPE is described as being in the high-teens, with readings well above that mark signaling premium prices and potentially muted future returns. The precise interpretation depends on the data series and the market in question, but the overarching idea is that valuations matter for long-run risk and return.
- Portfolio and risk considerations: For investors, CAPE is a tool for gauging the risk/reward embedded in equities. A high CAPE reading can justify more cautious allocation to risk assets or greater emphasis on capital preservation, while a low CAPE may encourage higher exposure to equities with the expectation of stronger long-run returns. It is not a precise predictor of short-term moves, but it informs stance on risk tolerance, horizon, and diversification. See Mean reversion and Discount rate for related ideas on valuation dynamics.
- Cross-market and historical context: While CAPE has become a staple in evaluating the US market, economists apply the idea of cyclically adjusted earnings to other markets as well. Comparisons across countries must account for differences in accounting standards, dividend practices, earnings quality, and the structure of corporate taxation. See Valuation and Capital markets for broader context.
Limitations and debates
- Structural shifts and measurement issues: Critics point out that CAPE can misread markets when structural changes occur—such as longer-living firms with persistent earnings power, higher intangible asset intensity, or a secular decline in dividend payouts. The reliance on real earnings means that periods with unusual inflation or tax regimes can distort the denominator, complicating comparisons across time. See Earnings and Inflation for related concepts.
- The effect of monetary policy and rates: Because CAPE uses a price relative to earnings, shifts in the discount rate and the cost of capital can influence readings in ways that aren’t purely about corporate performance. Some observers argue that extremely low interest rates, common in recent decades, can push prices higher even when earnings aren’t rising, while others say low rates justify higher valuations. Debates about how best to account for interest rates in valuation are ongoing, with variants like CAPE 2.0 illustrating attempts to address this tension.
- Practical forecasting limits: A recurring point in the literature is that CAPE is better at signaling long-run tendencies than at predicting short- to medium-run market moves. Its reliability varies by regime and market, and there is no consensus on a single, universally reliable threshold for “too expensive” or “too cheap.” See Historical performance of CAPE and Forecasting stock returns for related discussions.
- Policy implications and political economy: While CAPE is a market-based signal of valuation, its use in policy debates is limited. Advocates emphasize that markets allocate capital efficiently when prices reflect fundamental prospects, arguing against heavy-handed intervention aimed at manipulating asset prices. Critics may point to structural impediments to investment or to distributional concerns when valuations run high, but the central case for CAPE remains anchored in market-based assessment rather than activist policy.
Applications in policy and markets
- Investor decision-making: Institutions and individuals use CAPE as part of a broader framework for assessing risk, expected returns, and portfolio structure. It feeds into discussions about equity exposure, bond risk premia, and the balance between growth and value styles within an equity sleeve.
- Market commentary and research: CAPE figures appear in policy-adjacent research and in market commentary as a shorthand for “whether valuations are stretched.” It intersects with concepts like Market efficiency and Valuation in explaining how prices relate to expected fundamentals.
- Limitations in cross-sectional use: While CAPE can illuminate differences across regimes and periods, it is not a universal measure of value. Differences across economies, regulatory environments, and corporate capital structures mean that CAPE should be interpreted in context rather than as an absolute rule.