Don’t Panic Over CAPE

A popular topic of conversation amongst equity investors is the Shiller Cyclically-Adjusted Price-Earnings, or CAPE ratio. Specifically, investors are concerned by the elevated level of CAPE in relation to its ‘historical mean’. CAPE is a valuation measure calculated by dividing an inflation-adjusted index with the average of its inflation-adjusted annual earnings over the past 10 years. High valuation periods are taken to predict lower expected future returns and increased risks of significant drawdowns. Before we validate or dismiss this fear there are two material questions to ask: is CAPE a perfect measure of valuation and is it accurate in signaling market tops and bottoms?

Take CAPE for the S&P 500 as an example.  The price of the S&P 500 is straightforward – it’s the S&P 500’s current level adjusted for inflation. Earnings, as you will see, are much less straightforward. Changing accounting rules render the earnings used in CAPE inconsistent over time.   After adjusting for these changing rules, the CAPEs become more moderate and closer to the long term average. Furthermore, the shift in corporate strategy to share buybacks over dividend payouts create changes in earnings per share which cause inflated CAPE valuations even when there’s no difference in the underlying company (again, from the post linked above).  Jeremy Siegel, legendary professor at the Wharton School of Business, raises additional issues on the inaccuracy of earnings used in CAPE in this May 2013 paper stating that, after adjustments, “the overvaluation of the current market largely disappears.”

But let’s ignore these issues with CAPE and accept its current valuation as true. What are the implications of high valuations and how could they be resolved? A correction driving down the price of the S&P 500 will bring the ratio back to the ‘safe zone’, but an increase in earnings or interest rates can accomplish the same without necessarily upsetting the market. There is research that suggests PE ratios alone explain very little variation in stock prices. Some scholars even believe that CAPE contains less information on forward returns than conventional PE, today’s level of which is 19.85 vs CAPE’s 26.48.  The theory behind CAPE is that valuations must regress to the mean but that point is also up for debate – behavioral research suggest that economic agents (equity investors in this case) care more about short term gains undermining the efficient market framework and causing under- or over-valuations to last for long periods of time before any ‘correction’.

To review, the efficacy of CAPE’s measure of valuation is limited by changing corporate and regulatory environments, including:

• Inconsistent measurement of earnings across time
• Share buybacks
• Lower dividend payouts

There is also widespread disagreement in interpreting CAPE’s output:

• A market correction, increase in earnings or change in interest rates can accomplish the same thing
• Do PE ratios explain variation in stock prices? Is CAPE better than traditional PE?
• Does investor behavior conform to CAPE’s predictions?

The market’s valuation is probably not as high as CAPE suggests and even if it were, lower future returns or a significant market drawdown are no guarantee. CAPE provides some level of insight to the market but fears that equities are doomed are sensationally overstated.