What Is The CAPE Ratio?
The cyclically-adjusted price-to-earnings (CAPE) ratio is a variation on the standard price-to-earnings (PE) ratio that seeks to determine if stocks are in a bubble. While the more common PE ratio measures a stock or stock index's valuation over the next year or so, the CAPE ratio is calculated by using an average of corporate earnings over the past 10 years, adjusted for inflation.
By using 10 years of earnings, the CAPE ratio seeks to measure corporate profits through various economic cycles, rather than just one year, which may skew the results if it's a particular good or bad year. It also considers fluctuations in the overall economy on stock prices and corporate earnings. Essentially, it tries to smooth out the cyclical effects of the economy on earnings.
An extremely high CAPE ratio could mean stocks are overvalued compared to what their earnings would indicate and may therefore be subject to correction. As a result, the CAPE ratio seeks to determine if the market is in a bubble or not.
The CAPE Ratio was devised by Robert J. Shiller, Sterling Professor of Economics at Yale University, who won the Nobel Prize in economics in 2013, along with Eugene F. Fama and Lars Peter Hansen, for their "empirical analysis of asset prices." Shiller is credited with warning about the technology stock bubble in 2000 and the U.S. housing market bubble that precipitated the financial crisis of 2008.
The mathematical formula for the CAPE ratio is: CAPE Ratio = Price/average earnings over 10 years adjusted for inflation
CAPE Ratio Criticisms
While the CAPE ratio is another tool for investors to value stock prices, it has been criticised for being inherently backward-looking and therefore of limited utility for predicting the future path of stock prices and valuations.
Likewise, the ratio is computed by using earnings under generally accepted accounting principles (GAAP), which have changed substantially over the years. this can skew a CAPE ratio measurement compared to how it was measured in the past. It also fails to consider changes in tax policies, which can also have a profound effect on corporate earnings.
The CAPE ratio is a variation on the standard PE ratio that seeks to determine if stocks are overvalued by measuring corporate earnings over a 10-year period, rather than just one year, in order to smooth out the effects of economic cycles. The CAPE ratio was created by Nobel Laureate Robert Shiller of Yale University, who studies asset bubbles.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…