The CAPE Ratio, also referred to as the Shiller PE Ratio, or cyclically-adjusted price-to-earnings ratio, is a useful tool, to get a broad view of the stock market position.

Essentially, it is a way to gauge whether the equity market is overvalued, or undervalued.

The CAPE Ratio indicator was developed and popularized by Yale economist Robert Shiller. He is famous for his work in behavioral finance and empirical analysis of asset prices.

Some of his work is amazing to read, but there are also some topics, where I disagree strongly with his analysis and think that he doesn’t really get the whole picture.

Schiller also runs a website, on which he has a lot of valuable data for doing economic research, in case someone is interested.

How Does the CAPE Ratio Technically Work?

The price-to-earnings (P/E) ratio is a commonly used ratio. It measures the current stock price (P) in comparison to its earnings per share (E). It is a very common tool used by investors to evaluate a company.

In essence, this ratio tells investors how many years, it would take the company to earn enough money at the current rate, to make up for the investment price.

Here is a quick example:

In this example, there are two companies, Ataraxia Inc. and Delusional Inc.

Both companies are profitable. They have issued the same amount of shares (20,000) and both companies are able to generate the same profit ($30,000).

Thus, they also come to the same EPS ratio ($1.50) which is calculated by dividing the net income by the number of outstanding shares.

The net income is the profit of a company and the money that can either be paid out to its shareholders over time in the form of dividends, or alternatively be reinvested to further grow the business.

The main difference in our example is that there is a huge difference in the stock price. Delusional Inc.’s market value is much higher than that of Ataraxia Inc.

Therefore, there is also a huge difference in the P/E ratio. While Ataraxia is trading at a P/E of 6.67, Delusional Inc. is trading at a P/E of 53.33.

In other words, assuming the current earnings remain unchanged and both companies pay out all of them in dividends, an investor of Ataraxia Inc. would make back all of his initially invested money after 6.67 years. (Or, to be exact, even a bit more than 100% after 7 years, assuming the dividends are paid every 6 months).

A 100+% return after 7 years, with $10.50 (14*$0.75) in dividends, while still owning the share.

While getting paid the same dividends, our Delusional Inc. investor on the other hand, would need to wait 53.5 years until he gets the amount of his originally invested money back in dividends.

Therefore, the return on investment for him is much lower.

Generally speaking, the goal of an investor is to buy a share for a low price, to get plenty of earnings for the invested money.

Of course, an economy is a constantly changing and developing organism and therefore in reality things are more complicated and nuanced. There might be very good reasons for Delusional Inc. having such a high P/E ratio.

For instance, they are just about to break-through with an amazing new innovation, or they just started with a phenomenal management team, that is expected to build an awesome business in the coming years.

A totally different — but also viable — explanation could be that they have donated lots of money to the political party that just won the elections and since they also have good connections with the industry regulators, thanks to persistent lobbying over the years, it is expected that they can turn that into their favor and at the same time make life harder for Ataraxia Inc., which decided to stay away from the political circus.

Or… it might of course also just be due to a bunch of delusional investors.

In any event, in the above example, we just looked at the current P/E ratio and based the analysis on it.

The problem is, that due to various factors, the earnings of companies might fluctuate a lot over time and make it difficult to evaluate the accuracy of the current P/E ratio. Furthermore, in events like a recession, where both stock price and earnings fall rapidly in an erratic manner, the P/E ratio might give wrong signals.

Thus, in a constantly changing economy, it might be advantageous to take a step back and watch the performance of companies over time.

This is where the CAPE Ratio comes in and extends this very useful P/E valuation metric, to also include changes over time in its assessment.

What the CAPE Ratio does, is taking the average of the inflation-adjusted earnings from the previous 10 years, instead of just looking at the most recent earnings.

Moreover, this practice can be extended to not only look at individual companies, but taking the aggregate price of shares of a group of companies and dividing them by the aggregate and inflation-adjusted average earnings over the previous 10 years.

Through this methodology, the P/E ratios of indices (most prominently the S&P 500 index) can be analyzed over time. This allows, to get a more advanced evaluation tool, which can be used to assess the overall stock market, trends and also serve as a general indicator.

The CAPE Ratio as Investment Tool

By indicating how stocks are evaluated in comparison to what they are earning, an investor can come to three basic conclusions:

1. Stocks are undervalued → it might be the right time to invest.
2. Stocks are overvalued → it might be a good moment to sell.
3. The stocks are fairly valued → It might be good to hold, but also to be cautious.

Note: The CAPE Ratio is most commonly applied to the S&P 500, but theoretically it can also be applied to any other stock index.

From an investment perspective, it can be a helpful tool when it comes to portfolio allocation. For instance, it can help to decide:

• What portion of the portfolio should be invested in the equity market (the higher the CAPE Ratio, the lower the allocation).
• By comparing CAPE Ratios of different stock indices, or even countries, an investor might reallocate his investments to other equity markets, based on the ratio.

Zooming out, the CAPE Ratio of the S&P 500 historically looks like this:

It can be seen that the CAPE Ratio had some really significant swings. Especially, the chart really shows the stock market exuberances that happened in the ‘Roaring Twenties’ and throughout the Dotcom bubble in the late 90s.

Shiller and other researchers have shown in various studies, how the CAPE Ratio is correlated to stock returns over the following years.

The basic findings across the board — unsurprisingly — suggest that there is quite a strong correlation. It is quite intuitive that whenever the CAPE ratio is low, the investments are likely to be profitable over the preceding years. On the other hand, it also makes sense that the reverse should hold true, when the CAPE Ratio is very high.

Here is a chart that shows how investments at different CAPE Ratios have performed over the following 10-15 years. The table on the right side also looks at the performance across several countries:

It can be seen, that investing in the main stock index at times in which the CAPE Ratio was below 10, guarantied a return of at least 7.3% over the following 10-15 years (expect for Japan, because the CAPE Ratio of the Nikkei never fell below 15).

It also shows, that investing at a time in which the CAPE Ratio was above 30, was followed by weak, or often even negative returns over the preceding 10-15 years.

Thus, we can conclude, that at least historically, the CAPE Ratio has offered a valuable gauge for investors.

Here are some basic statistical data points:

• Mean: 16.99
• Median: 15.89
• Min: 4.78 (Dec 1920)
• Max: 44.19 (Dec 1999)

The main data point to look at, is the mean of 16.99 → we are currently at 28.73.

How to Think About the Current CAPE Ratio?

The above posted “CAPE Ratio” chart shows that we are currently at a really high level. Even though the ratio has somewhat declined since the peak at the start of the year, standing now at 28.73, it is still in a territory that was only exceeded at the start of the Great Depression in 1929 and at the height of the Dotcom bubble in 1999.

Based on historic observations, we should expect very low or negative stock market returns over the coming decade(s).

How much further could stock markets decline, based on historic observations?

Taking the average of 16.99 as a benchmark, this would bring the S&P 500 down to 2,336, which would mean a further decline of 41% from current levels (at 3390). The S&P currently has a market capitalization of about $30 trillion. Hence, if we would see such a decline, this would mean that $12.3 trillion would evaporate. Not even taking into consideration, what ripple effect that would have on all the other global markets.

Moreover, if we assume a scenario, in which it falls below its average, the potential meltdown could be even more severe.

The world would suddenly need to realize, that it is a lot poorer than it currently believes to be.

That’s also why readers of my newsletter by now should be quite familiar with the red or orange colored warnings about the high level of the CAPE Ratio in my Key Indicators table.

There are of course counter arguments to this assessment and in recent years, many analysts have debated, whether this metric is still a viable way, to assess market valuation. Some arguments against it are:

• The CAPE Ratio is outdated because the business environment has changed and a more innovation driven economy allows for more growth potentials and therefore higher P/E ratios.
• Updated accounting rules have also changed how corporate earnings are calculated and therefore also alter the CAPE Ratio.
• The CAPE Ratio has been quite high for a long time (the S&P CAPE Ratio hasn’t been below 15 since 1990) and that suggests that the general environment has changed and we shouldn’t pay too much attention to outdated valuations.

I think that these criticisms have a point, but I think they are wrong. I still think that in essence, the CAPE Ratio is a very important metric to look at.

My general economic thesis is, that we have totally lost the view of real pricing in our economy. The most important price in the economy is controlled and managed by the Fed Committee, consisting of 12 voodoo academics, it is not discovered naturally on the market.

It might not be a pure coincidence, that the constant decrease in the core interest rate since 1981, has happened throughout the same period in which the CAPE Ratio has been generally trending higher.

In fact, I think a huge factor for the constantly high CAPE Ratio can be directly linked to the big debt cycle and low interest rates. We have had easily available credit and this has led to massive money expansion over the last decades.

In a world in which central banks would suddenly and miraculously cease to exist, we would see rates rising even quicker than now, which would lead to a big collapse of the whole financial system. Consequently, the CAPE ratio would also come down to historically normal levels. In a turbulent financial collapse, it would probably fall even well below its historic average.

We are obviously in a very different world though: A world in which the whole investment world is anticipating, speculating and trembling, about what is going to be the next move of the Fed. In this world, everything is possible. We might see even a higher CAPE ratio in the future.

To conclude, I think the CAPE Ratio is a valuable metric and I think it currently shows that we are in an equity asset bubble. Thus, in a world with a natural interest rate (e.g. in a world in which Bitcoin has reached the status of being the main global reserve currency), stock prices would fall substantially.

As long as the Fed keeps rising rates and tightening the money supply, we are likely going to see stock prices falling and the ratio declining.

However, I believe that the Fed will — politically and/or economically — be pressured to pivot its current path at some point and revert back to massive money printing. When this happens, we could see the CAPE Ratio trending upwards again and potentially even reach new heights.