Understanding the CAPE Debate: The History of 24 or More

By Keith C. Goddard, CFA, Channing S. Smith, CFA, and Monty L. Butts

February 25, 2014

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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

At its recent level near 25, the cyclically adjusted price-to-earnings ratio (CAPE) of the U.S. stock market suggests that stocks are very richly priced or that there is something wrong with the CAPE. Debate about these two explanations intensifies each time the ratio ticks higher. This article offers objective data to help readers decide for themselves.

The purpose of a CAPE is to smooth out temporary fluctuations in corporate profits by using a 10-year rolling average of earnings to calculate the price-to-earnings ratio of the stock market. The most widely followed version of CAPE for domestic equities is maintained by Yale economist, Robert J. Shiller. All of the CAPE data for this article come from Dr. Shiller’s public database.

It shouldn’t be surprising that criticism of the Shiller CAPE gets louder the higher the ratio climbs. Historically, when the starting point for the CAPE has been high, subsequent returns in the stock market have been low. Since the CAPE’s recent levels have been discouraging, it’s tempting to search for a flaw in its logic.

The most vocal critic has been Wharton finance professor Jeremy Siegel, who argues that changes in accounting standards, shifting industry weightings in the composition of corporate profits and excessive write-offs during the financial crisis have caused Shiller’s methodology to understate corporate earnings and overstate the CAPE relative to longer-term historical values. Siegel and Shiller delivered presentations on the topic at a conference last fall, as described by Laurence Siegel in a Feb. 18 Advisor Perspectives article.

Our contribution to the conversation is data. The research team we lead at Capital Advisors has correlated historical readings for the Shiller CAPE with subsequent outcomes in the U.S. stock market as of every month-end since 1926. For this article, we carved out a subset from the data that includes every 3-year and 5-year holding period that began with a Shiller CAPE of 24.0 or higher. The threshold of 24.0 was chosen to reflect the recent trading range for the CAPE, and because 24.0 marks the approximate threshold for the highest 15% of all readings since 1926. Our objective is to capture the experience of the U.S. stock market when its initial condition is “expensive,” as defined by a Shiller CAPE within the highest 15% of its historical range.

Every holding period presented below includes the beginning date, the starting and ending CAPE and the cumulative return, including dividends, during the period. Readers can draw their own conclusions from the data, but here are a few observations we find noteworthy:

  • High CAPE values occur infrequently within the historical range of possibilities.
  • There have been 57 monthly observations since 1926 (5.6% of all observations) when the CAPE measured 30.0 or more, 55 of which occurred during the boom-to-bust stock market cycle between 1997 and 2002.
  • The average annualized return for all 3-year holding periods that began with a CAPE of 24 or higher has been 2.85%, while the average return for all 5-year periods was 1.88%.
  • Of the 152 3-year measurement periods that began with a CAPE of 24 or more, 49% resulted in a negative cumulative return, while 42% of all 5-year periods were negative.
  • Investors may choose to adjust the data to reflect structural changes like those Jeremy Siegel describes (i.e., a CAPE of 25 today might be similar to a historical CAPE of 22, or some other estimate).

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