H/T Barry Ritholtz, The Big Picture

Executive Summary

  • The Cyclically-Adjusted Price-to-Earnings Ratio (CAPE) is bumping up against values that have previously preceded major market declines. Some observers take this to mean that a crash is imminent, but the real story is more nuanced.
  • Price-to-earnings ratios-the CAPE included-are a shorthand way of expressing expectations for future earnings growth.
  • CAPE’s implied growth rates were a fairly good estimator of future growth before the Great Depression and War Years, but have consistently underestimated actual earnings growth in the post-War period.
  • Future growth rates as implied by the present CAPE value signify the market believes the U.S. economy will perpetually grow at the same average rate it has in the post-War period.

CAPE: A Brief Overview

The PE Ratio, as commonly used, has numerous issues which make its applicability for investing questionable. The most serious problem with the PE ratio brought up by Shiller in his best seller, is that a single year’s worth of earning s is too small of a window to get a true view of the power of a firm to generate profits over time. This inadequacy is due to a myriad of factors, including problems of accounting timing and cyclical changes to profitability.

To correct for this “small window” issue, Shiller provides a statistic that has since come into common use in the financial industry: the cyclically-adjusted price-to-earnings ratio or CAPE (also sometimes known as the “Shiller PE” or “PE10”). CAPEs are calculated by dividing the present price of a stock by the average earnings of that company over the previous 10-year period. In his book, Professor Shiller adjusts the prices of U.S. stocks and their earnings by inflation, and builds an historical series of the CAPE for the U.S. index starting in 1881. The charted data, which is available on YCharts or through Professor Shiller’s own website, is shown in Figure 1:

CAPE ratio

Even casual observers’ eyes’ will be drawn to the two dates 1929 and 2000; it is also noteworthy that the present CAPE value of 25.96 is close to the 2007 value and is well above the historical average value of 16.6.

Professor Shiller is a skilled economist, well-versed and expert in the use of statistics to draw causal connections, and in his book, he draws a nuanced, measured conclusion from his study of the index CAPE numbers.

How Not to Interpret the CAPE

Unlike Professor Shiller, Wall Street is not known for nuance, measured prognostication, or appropriate use of statistics, so various pundits look at Figure 1 and make the following argument without hint of reservation or doubt:

Cape

While this syllogism is valid, it might not be true. Financial ratios do not reflect constants of nature, so simply because the present value of a given ratio is higher or lower than an historical value of that ratio or a measure of its historical central tendency, holds little meaning. To assess the importance of the present CAPE level, we must take a closer look at the basic concept of the PE Ratio to see what it is telling us about how market participants view the world.

The PE Ratio as a Shorthand Growth Metric

According to financial theory and common sense, the price of an asset should be directly related to the profit the asset creates for its owners over its entire economic life. That economic life is perpetual for all companies assumed to be “going concern” To find the present value of the future earnings of a company in perpetuity, financial theorists use the Gordon Growth Model.

Cape

YCharts the Big Picture-Shiller’s CAPE