The CAPE Ratio

What is it and why do I care?

The CAPE ratio is the Cyclically Adjusted Price Earnings Ratio developed by Robert Shiller, Professor of Economics at Yale University. It takes the current price of the S&P 500 compared to average earnings over the past 10 years. It also adjusts prior years for inflation, so everything is in today’s dollars.

The CAPE ratio is my preferred metric to determine whether the stock market is reasonably valued.  Other popular metrics like the Price/Earnings fall short because they are based on current earnings which could be depressed in a recession or inflated when profit margins are at peak levels in the business cycle.  For example, in 2009, the simple P/E ratio for the market was 71 which looked crazy expensive because earnings were depressed from the recession.  However, with the CAPE ratio at 13.3, you would have been convinced this may have been the buying opportunity of a lifetime.   It was one of the few times my equity exposure was over 80%.  In March 2009, the S&P 500 was trading at 666.  Today it is over 3,000.  I have found the CAPE ratio to be the most reliable metric for determining long term future returns in the market.
 
The experts say you cannot time the market.  In the short run, I agree.  Valuation does a lousy job of predicting short term market moves.  In 1999, I thought the NASDAQ (tech stocks) was extremely overvalued when it was at 3370.  I refused to cave and invest in these overvalued tech stocks.  I thought if I really felt this way, why not put real money behind it?  So, I did.  In 1999, I put on a short position on the NASDAQ (with shorting, you make money when stocks go down).  Day after day, week after week, the market continued to climb until it reached 5050 in March of 2000, which was an increase of 50% since I put on the short position.  It felt like every day we were losing money.  After several months of losing money, it was not fun anymore.  I just wanted out.  Once the market came down to my break even point, I covered the short position.  Eventually, I was right, but I did not profit from it.  In fact, by September 2002 the NASDAQ had fallen 66% from when I shorted it and it fell 77% from the peak.  There is a common phrase short sellers use; “Markets can remain irrational longer than I can remain solvent.” These days I still short stocks but only as a hedge against long positions.  If the market is very overvalued, its best to just avoid it vs trying to profit from a decline.

Back to the CAPE ratio….
 
Over the past 150 years, the low point for the CAPE ratio was 4.8 in 1920.  The record high was 44.2 in 1999 during the tech bubble.  The 150-year average is 16.7.  Today the CAPE ratio is 28.5 which is rich given the current economic climate.  As shown below, when the CAPE ratio is low, 10-year future returns are high.  When the CAPE is high, future returns are low.             
 
 
 
 

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At today’s CAPE ratio, the market is priced to deliver basically nothing over the next 10 years.  In my opinion, it could be even worse because today’s ratio goes back to 2010 therefore it does not include any recession earnings which was the original intent of the ratio.  Normally, 10 years is long enough to capture the peaks and valleys of the business cycle.  When I was in school, we were taught you can expect a recession every 4-5 years.  Today is unique because we are in the longest economic expansion in our history (until COVID hit us).  I deal with this issue by going back 11 years and including 2009 earnings in the calculation.  At the end of 2020, this won’t be necessary because the depressed earnings of 2020 will be baked into the numbers.
 
With my adjustment, The CAPE Ratio today is 31.
 
Ben Graham (Warren Buffett’s mentor) said you should never have more than 75% or less than 25% of your portfolio in stocks.  I think this is sound advice.  People often talk about being “in the market” or “out of the market.” It should not be a binary decision.  With few exceptions (like today), I am rarely 100% stocks or 0% stocks.  I like to adjust exposure based on valuation.  When stocks are cheap, future returns are high and downside risk is limited.  This is the time to increase exposure.  When stocks are expensive, future returns are low and downside risk is significant.  This is the time to lighten up on exposure. I realize this is easier said than done.  Very few people wanted to sell stocks in 1999 during the tech bubble or in 2007 during the housing bubble.  Nor could I find anyone excited about buying stocks in 2002 or 2009 after experiencing 50%+ declines.  Most can tolerate 20-30% declines like we just experienced in March of this year.  However, declines over 50% can be life changing, especially if you are over 50. 
 
So how can I use the CAPE Ratio to manage my portfolio?
 
When it comes to estimating future returns, I like to make things complicated and factor in future growth rates, inflation, dividend yields etc.  But for someone who does not want to make a career out of it, I found the following framework to be helpful:

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Given today’s market valuation over 30x, I had to come up with a new category above “very expensive” called “crazy expensive.” This is one of those rare occasions when I took our U.S. exposure to 0%.
           
If you would like to follow the CAPE Ratio real time or check out some cool charts and tables, you can find it here:
 
www.multpl.com/shiller-pe/
 
Questions or comments, feel free to email me at [email protected]
 
Disclaimer: Askfinanceguy.com is not an investment advisor, brokerage firm, or investment company.  This blog is for educational and/or entertainment purposes only. Use this information at your own risk. Do not consider anything on this page to be legal, tax, or investment advice.