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.
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%.
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