A Cautionary Note About Robert Shiller’s CAPE
One measure of market valuation that has become widely popular is the CAPE, the cyclically adjusted price-earnings ratio. It was developed by Robert Shiller, a professor of economics at Yale University and author of “Irrational Exuberance” (Crown Business, 2006).
Shiller defines the numerator of the CAPE as the real (“inflation-adjusted”) price level of the S&P 500 index and the denominator as the moving average of the preceding 10 years of S&P 500 real reported earnings, where the U.S. Consumer Price Index Table 1 provides a detailed example of how the CAPE is determined.is used to adjust for inflation. The purpose of averaging 10 years of real reported earnings is to control for business cycle effects.
In this article
- The Length of the Business Cycle
- Measuring Inflation
- Accounting and Tax Issues
- Fair Value Accounting
- Summary and Conclusions
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It is frequently suggested that the CAPE should be considered a mean-reverting series. As can be seen in Figure 1, the CAPE was reported as 23.35 during the month of July 2011 on the Irrational Exuberance website (www.irrationalexuberance.com). Per an analysis frequently used in practice, comparing the July 2011 CAPE to its long-term average of 16.41 indicates that U.S. stocks are currently overvalued by 42.3%.
In contrast, on July 22, 2011, Standard & Poor’s reported a price-earnings ratio of 16.17 based on reported earnings for the S&P 500 index. The price-earnings ratio based on operating earnings (which excludes write-offs and other special items) was 14.84. Both of these measures are well below their average since the fourth quarter of 1988, which suggests that stocks are certainly not overvalued to the degree predicted by the CAPE analysis and may actually be undervalued. Thus, investors are left in a quandary as to which measure of valuation is most appropriate.
This article makes the case that the comparison of the July 2011 CAPE to its long-term average provides an overly bearish view of the stock market and that the traditional price-earnings ratio based on either reported earnings or operating earnings is a better measure of the worth of U.S. equities in July 2011. As first used by Shiller in his book, the CAPE was undoubtedly a very useful tool for identifying overvaluation at the height of the late-1990s stock market “bubble.” However, like all other valuation metrics, the CAPE has its limitations, and these limitations derive from how it is computed.
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