Building a Better CAPE Ratio

October 5, 2022

After a bit of a hiatus from the blog – thanks to our ambitious summer travel schedule – it’s time for another post. Over the years, I’ve gotten a lot of questions about the Shiller CAPE Ratio and if it’s still relevant. If you’re a regular reader of my blog, you’ll likely be familiar with the CAPE concept, but just as a refresher, Prof. Robert Shiller, economist and Nobel Laureate, came up with the cool idea of calculating a Price-Earnings (PE) ratio based not just on 1-year trailing earnings, which can be very volatile, but on a longer-term average to iron out the corporate earnings fluctuations over the business cycle. Hence the name Cyclically-Adjusted Price Earnings (CAPE) Ratio. If we use a 10-year moving average of inflation-adjusted earnings as the denominator in the PE ratio, we get a measure of market valuations that’s more informative in many instances. For example, historically the CAPE ratio has been significantly negatively correlated with subsequent equity returns. It’s not useful for the very short-term equity outlook, but over longer horizons, say 10+ years, the CAPE ratio has been highly informative. Especially retirees should take notice because your retirement success hinges a lot on those first 10 or so retirement years due to Sequence of Return Risk. In fact, all failures of the 4% Rule occurred when the CAPE was above 20! A high initial CAPE ratio signals that retirees should probably be more cautious with their withdrawal rate!

But the CAPE has been elevated for such a long time, people wonder if this measure is still relevant. In the comments section, people ask me all the time what kind of adjustments I would perform to “fix” the CAPE. Can we make the Shiller CAPE more comparable over time, to account for different corporate tax environments and stock buybacks and/or dividend payout ratios over the decades? Yes, I will present my ideas here today. And even better, I will post regular updates (potentially daily!) in my Google Drive for everyone to access for free.

So, what do I find? The adjustments certainly lower the CAPE, but don’t get your hopes too high. Even after the adjustments, the CAPE is still a bit elevated today! Let’s take a look at the details…

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