How is the Shiller CAPE ratio calculated, and what are its strengths and limitations for market valuation?

Question

AcadiFi · Accepted Answer

The cyclically adjusted price-to-earnings ratio (CAPE), developed by Robert Shiller, smooths out business cycle fluctuations to provide a long-run valuation anchor. It is the most widely cited metric for assessing broad market valuation levels.

**Calculation**

CAPE = Current Real Price of S&P 500 / Average Real Earnings over Prior 10 Years

Both numerator and denominator are adjusted for inflation using CPI, so the ratio compares apples to apples in constant purchasing power terms.

**Why 10 Years?**

A typical business cycle lasts 5-10 years. By averaging earnings over a full decade:
- Peak earnings don't make the market look cheap (as trailing P/E would)
- Trough earnings don't make the market look expensive
- Structural shifts in profitability are partially captured

**Worked Example — Interpreting Market CAPE:**

| Period | CAPE | Subsequent 10-Year Annualized Real Return |
|---|---|---|
| 1982 (market bottom) | 7.4x | 14.1% |
| 1999 (dot-com peak) | 44.2x | -3.4% |
| 2009 (financial crisis low) | 13.3x | 13.2% |
| 2026 (current) | ~33x | ? |

Historically, high CAPE levels are associated with lower subsequent long-term returns, though timing is unreliable.

**Strengths:**

1. **Smooths cyclicality** — eliminates the distortion of single-year earnings
2. **Long track record** — data back to 1871 allows historical comparison
3. **Predictive power** — statistically significant negative correlation with future 10-year real returns
4. **Inflation-adjusted** — handles different monetary regimes

**Valid Criticisms:**

1. **Accounting changes:** Earnings quality has changed over 150 years. Post-SFAS 142 (goodwill impairment rules since 2001) and increased write-offs depress average earnings and inflate CAPE.
2. **Payout shift:** Companies now return cash via buybacks rather than dividends. Lower shares outstanding mean higher EPS growth, which the 10-year average lags.
3. **Sector composition:** Today's market is dominated by high-margin tech; 1920s were industrials and railroads. Higher structural margins justify a higher CAPE.
4. **Interest rate environment:** Low real rates justify higher multiples. CAPE does not adjust for the opportunity cost of capital.
5. **Mean reversion speed:** CAPE has stayed above its long-term average of 17x for most of the past 30 years, frustrating value-oriented timing strategies.

**Practical Usage:**

- CAPE is best used as a **strategic asset allocation tool**, not a market timing signal
- Compare current CAPE to a range of scenarios, not a single "fair value"
- Complement with other metrics: equity risk premium, Tobin's Q, Buffett indicator (market cap / GDP)

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How is the Shiller CAPE ratio calculated, and what are its strengths and limitations for market valuation?

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