CAPE Ratio (Shiller PE)
What is the CAPE Ratio?
The CAPE Ratio (Cyclically Adjusted Price-to-Earnings Ratio) is a valuation measure developed by Nobel laureate Robert Shiller that compares the current price of a stock index to the average of its inflation-adjusted earnings over the previous 10 years. It is also known as the Shiller PE, PE10, or P/E10.
The regular PE ratio uses just one year of earnings, which creates a problem. During economic booms, high earnings make stocks look cheap even when prices are elevated. During recessions, depressed earnings make stocks look expensive even when prices have fallen. The CAPE ratio solves this by averaging a full decade of earnings, which smooths out the business cycle and provides a more stable baseline for valuation.
Robert Shiller and John Campbell first published research on this metric in the late 1990s, demonstrating that the CAPE ratio had strong predictive power for long-term stock market returns. Their work showed that when the CAPE was high, subsequent 10-year returns tended to be low, and when the CAPE was low, subsequent returns tended to be high.
For value investors, the CAPE ratio serves as a big-picture check on market conditions. While it cannot tell you which individual stocks to buy, it can help you set expectations for future returns and adjust your overall allocation between stocks, bonds, and cash. When the CAPE is well above its historical average, value investors tend to be more selective and hold more cash. When it is well below average, they invest more aggressively.
How to Calculate the CAPE Ratio
The CAPE ratio formula is:
The steps to calculate it are:
- Gather the past 10 years of annual earnings per share for the index or stock.
- Adjust each year's earnings for inflation using the Consumer Price Index (CPI), bringing all values to current dollars.
- Calculate the average of these 10 inflation-adjusted earnings figures.
- Divide the current market price by this 10-year average.
For example, if the S&P 500 is at 4,500 and the average inflation-adjusted EPS over the past 10 years is $150, the CAPE ratio would be 30 (4,500 / 150).
The inverse of the CAPE ratio gives the cyclically adjusted earnings yield:
A CAPE of 30 implies an earnings yield of 3.3%, while a CAPE of 15 implies an earnings yield of 6.7%. This yield form is particularly useful for comparing stock valuations against bond yields and other asset class returns.
The inflation adjustment is important because it prevents rising prices from artificially inflating past earnings relative to the current stock price. Without this adjustment, the CAPE ratio during periods of high inflation would appear lower than the true valuation level.
What is a Good CAPE Ratio?
The long-term historical average CAPE ratio for the US stock market is approximately 16 to 17. This average spans over 100 years of market data and serves as the primary reference point for most investors.
Historical context for the S&P 500:
- Below 12: Historically associated with above-average future returns. These levels have occurred during severe recessions and bear markets, such as 1920, 1932, 1982, and briefly in 2009.
- 12 to 20: Around the historical average. Markets in this range have generally produced reasonable long-term returns.
- 20 to 25: Moderately elevated. Future returns have been somewhat below average, but the market can sustain these levels for extended periods.
- Above 25: Historically associated with below-average future returns. The CAPE reached 44 in 2000 before the dot-com crash and was above 30 before the 2008 financial crisis.
Important caveats apply to these ranges. The CAPE ratio has trended upward over the past several decades, and some analysts argue that the historical average is no longer the right benchmark due to changes in accounting standards, the shift toward higher-margin technology companies, structural changes in the economy, and lower interest rates. Others counter that fundamental valuation principles have not changed and that elevated CAPE ratios still predict lower future returns.
The most robust use of the CAPE ratio is relative rather than absolute. Comparing the current CAPE to its own history for the same market or index provides the most meaningful signal.
CAPE Ratio in Practice
The CAPE ratio has been used to identify major market turning points and set return expectations across multiple historical periods.
The dot-com bubble (1999-2000): The CAPE ratio for the S&P 500 reached approximately 44, more than double its historical average. Shiller published "Irrational Exuberance" in March 2000, warning that the market was in a speculative bubble. The subsequent crash vindicated his analysis, as stocks lost roughly half their value over the following two and a half years. Investors who used the elevated CAPE as a signal to reduce equity exposure avoided significant losses.
The 2008-2009 financial crisis: The CAPE briefly dropped below 15 during the worst of the crisis, reaching levels not seen since the early 1980s. Investors who recognized this as an attractive entry point based on the below-average CAPE benefited from the decade-long bull market that followed, during which the S&P 500 quadrupled.
International market comparisons: The CAPE ratio is widely used to compare valuations across different stock markets. Emerging markets have frequently traded at CAPE ratios below 15, while developed markets like the US have traded at ratios of 25 to 35 in recent years. This divergence has led many value investors to overweight international and emerging market stocks, expecting higher long-term returns from lower starting valuations.
Portfolio allocation decisions: Many institutional investors and endowments use the CAPE ratio as one input in their asset allocation models. When the CAPE is significantly above average, they might reduce equity allocations in favor of bonds, real estate, or cash. When it is below average, they increase equity exposure. This systematic approach prevents emotional decision-making and takes advantage of long-term mean reversion.
The critical limitation is timing. The CAPE ratio can remain elevated or depressed for years before reverting toward the mean. It is a useful tool for setting expectations over 5 to 10 year horizons but a poor tool for predicting market movements over months or quarters.
CAPE Ratio vs Related Metrics
CAPE Ratio vs PE Ratio: The standard PE uses one year of earnings, making it volatile and susceptible to temporary distortions. The CAPE smooths out the business cycle by using 10 years of data. For evaluating broad market valuation, the CAPE is more reliable. For evaluating individual stocks, the standard PE is more practical because company-specific changes over 10 years can render long-term averages misleading.
CAPE Ratio vs Earnings Yield: The CAPE earnings yield (1/CAPE) provides the same information in a format that is easier to compare against bond yields and other assets. When the CAPE earnings yield falls below the 10-year Treasury yield, stocks are offering less return per dollar than government bonds, which historically has been a warning sign.
CAPE Ratio vs Price-to-Book Ratio: P/B measures valuation relative to net assets, while the CAPE measures valuation relative to cyclically adjusted earnings. Both have predictive power for future returns, and some researchers have found that combining them produces better predictions than either metric alone.
CAPE Ratio vs EV/EBITDA: EV/EBITDA is more useful for comparing individual companies, while the CAPE is designed for broad market analysis. They serve different purposes within an investor's toolkit, with the CAPE focused on macro valuation and EV/EBITDA focused on micro valuation.
CAPE Ratio and Discounted Cash Flow: The CAPE implicitly reflects the market's expectations for future cash flows. When the CAPE is high, the market is pricing in strong future growth. A DCF analysis can help determine whether those expectations are realistic by explicitly modeling future cash flows and discount rates.
The Bottom Line
The CAPE Ratio is one of the best tools available for assessing long-term stock market valuation. Its 10-year smoothing approach eliminates the cyclical noise that distorts the regular PE ratio, providing a more reliable signal about whether markets are broadly cheap or expensive.
For individual investors, the CAPE is most useful as a guide for setting return expectations and adjusting portfolio risk levels. When the CAPE is significantly above its historical average, expect below-average future returns and be more selective with stock picks. When it is below average, consider increasing equity exposure.
The CAPE's main limitation is that it is not a timing tool. Markets can stay expensive or cheap for years beyond what the CAPE suggests. Combine it with bottom-up analysis using metrics like EV/EBITDA, free cash flow yield, and return on equity to build a well-rounded investment process that works at both the macro and individual stock level.