CAPE Ratio (Cyclically Adjusted Price-to-Earnings Ratio)
academic research · Shiller P/E, developed by Robert Shiller in 'Irrational Exuberance' (2000) (1998)
The CAPE ratio divides the current stock price by the average of ten years of inflation-adjusted earnings. By smoothing out short-term earnings fluctuations, it provides a more stable gauge of whether the market is historically expensive or cheap.
Core Concepts
The Problem
Standard price-to-earnings ratios can be distorted by a single year of unusually high or low profits, giving a misleading picture of underlying valuation.
The Claim
Extremely high CAPE readings have historically been followed by poor long-term stock returns, while very low readings have been followed by strong returns.
Key Evidence
- •Shiller's data shows that after CAPE peaked above 30 in 1929, the market crashed.
- •The CAPE ratio exceeded 40 during the dot-com bubble, after which equity returns were negative for over a decade.
Practical Implication
Institutional and individual investors can use the CAPE ratio to adjust equity allocations, reducing exposure when readings are in the top historical decile.
Nuance & Limits
The ratio has been criticized for being too bearish in an era of structurally lower interest rates, and it does not account for changes in share buybacks or accounting rules. It works best over a 7–10 year horizon, not for short-term timing.
Source Material
Citation Density
high
Related Ideas
Both are top-down valuation gauges; the CAPE ratio uses earnings cycles, while the Buffett Indicator uses GDP.
Gaps
- ⚠ Precision as a short-term market timer is low; the signal can stay elevated for years before a correction.
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