The Shiller CAPE Ratio

Robert Shiller, a Nobel Prize–winning economist, created the CAPE ratio (Cyclically Adjusted Price-to-Earnings) to solve a problem with standard P/E ratios: they are too sensitive to where we are in the business cycle. When earnings are at a peak, the P/E looks cheap. When earnings are in a trough, the P/E looks expensive. Shiller's solution: average earnings over the last 10 years, adjust for inflation, and compare the current stock price to that normalized number.

The CAPE ratio is also called the Shiller P/E or the P/E10 because it uses 10 years of earnings. The idea is elegant: by smoothing out the business cycle, CAPE should give you a more truthful picture of whether the market is cheap or expensive on a macro level.

But CAPE has serious limitations. It is better at identifying major bubbles and crashes than at timing the market. It works less well for individual stocks than for market indices. And it misses major structural changes in the economy, like the shift to services or the internet revolution.

This article teaches you how CAPE works, how to interpret it, why Shiller created it, and most importantly, where it fails. Understanding both the power and the pitfalls of CAPE will make you a more rigorous investor.

Quick Definition

CAPE = Current stock price (or index level) divided by the average of the last 10 years of inflation-adjusted earnings per share.

It smooths out cyclical swings in earnings by using a 10-year average instead of the trailing twelve-month earnings.

Key Takeaways

• CAPE solves the problem of cyclical earnings distortion by averaging 10 years of earnings and adjusting for inflation.
• A CAPE below 20 suggests the market is cheap relative to its historical average; above 30 suggests expensive.
• CAPE is useful for macro-level market valuation (is the S&P 500 expensive?) but less useful for individual stocks.
• CAPE works best at identifying major bubbles (2000, 2008, 2021) but is poor at predicting returns in the intermediate term (1–5 years).
• CAPE misses structural changes in the economy (shift to services, intangibles, tech), which permanently change fair valuations.
• For individual stocks, use normalized earnings (industry-specific adjustments) rather than a 10-year average.

Why Shiller Created CAPE: The Cycle Problem

In the late 1990s, the stock market was soaring. The S&P 500 P/E ratio had reached 40–50×, levels not seen since the great bubble of 1929. Many analysts and economists were dismissing the concern, saying: "Stocks are expensive, but the earnings are growing fast, so it is justified."

Shiller was skeptical. He believed the market was in a bubble. But the trailing P/E alone was not sufficient proof, because earnings were growing so fast that the trailing P/E could be ratcheted up with each positive earnings surprise.

His insight: Look not at trailing earnings, but at earnings averaged over a full business cycle. If you average out the cyclical swings, you can see the true structural valuation of the market.

His framework:

1. Take the last 10 years of real (inflation-adjusted) earnings per share.
2. Divide by 10 to get the average.
3. Compare the current price to that average.
4. The result: CAPE.

By using a 10-year average, Shiller was filtering out the cycle. The theory was that this would reveal whether the market was genuinely expensive or just cyclically expensive.

And Shiller was proven right: the tech bubble burst in 2000, and the market fell 50%. His CAPE-based analysis had captured the genuine excess that trailing P/E ratios had hidden.

How CAPE Works: The Mechanics

The formula is:

CAPE = Current Price ÷ (Average of Last 10 Years of Inflation-Adjusted Earnings)

Example:

• S&P 500 index level: 5,000.
• Sum of real earnings per share (last 10 years): $280.
• Average (CAPE denominator): $280 ÷ 10 = $28.
• CAPE: $5,000 ÷ $28 = 178×.

This is a simplified example, but the logic is clear: instead of using the current year's earnings (which might be at a cycle peak or trough), you use the decade average.

The inflation adjustment is important too. Without it, comparing the price to earnings from 10 years ago would be mixing dollars of different purchasing power. CAPE adjusts all historical earnings to today's dollars using the Consumer Price Index (CPI).

The CAPE Benchmarks: What Is Cheap, Fair, and Expensive?

Historical CAPE levels for the U.S. stock market:

• Below 20: Cheaply valued. The market is below its long-term average (which is roughly 16–17).
• 20–25: Fair value. The market is near its average.
• 25–30: Moderately expensive. Above average but not yet extreme.
• Above 30: Expensive. Near historical bubble levels. The 1950s had CAPE ~25; the late 1990s had CAPE ~40+.

Using these benchmarks as a guide:

• In 2009 (financial crisis trough): CAPE was ~13 (very cheap).
• In 2000 (tech bubble peak): CAPE was ~44 (very expensive).
• In 2008 (pre-Lehman crash): CAPE was ~27 (expensive but not yet bubble).
• In 2024 (recent levels): CAPE is around 30–35 (expensive, near bubble levels).

These CAPE levels correlate with future market returns. Markets that start with low CAPE (below 15) tend to have higher 10-year returns. Markets that start with high CAPE (above 30) tend to have lower 10-year returns. The relationship is not perfect, but it is consistent.

The Strength: CAPE Catches Major Bubbles

CAPE's greatest power is in identifying periods when the market is genuinely overvalued on a cyclically adjusted basis—i.e., when even after smoothing the cycle, the price is still unjustifiably high.

The tech bubble of 1998–2000 is the clearest example. Trailing P/E ratios were high (35–40×), but defenders said: "But earnings are growing 20–30%!" CAPE cut through the noise. It was 44× at the peak, showing that even on a 10-year normalized basis, the market was absurdly expensive.

Similarly, CAPE correctly identified 2008 as expensive (27×), and it showed the 2021 peak as expensive (35+×). In each case, major corrections followed.

CAPE also worked the other direction. In 2009, CAPE at 13× correctly signaled that the market was extremely cheap, despite the chaos of the financial crisis. Investors who bought equities then (either through dollar-cost-averaging or lump sum) at that CAPE level saw exceptional 10-year returns.

For a long-term investor making a macro allocation decision—"Should I be 60% stocks or 40% stocks?"—CAPE at an extreme level (very high or very low) is a useful signal.

The Weakness: CAPE Predicts Peaks and Troughs, Not Timing

Here is where CAPE breaks down: It is excellent at identifying extremes, but poor at timing the market within a given regime.

A CAPE of 30× is expensive. But the market can stay expensive—and go higher—for years before it corrects. A CAPE of 20× is fair, but the market can rise or fall from there depending on interest rates, economic growth, and investor sentiment.

The problem is that CAPE is based only on earnings and price. It does not account for:

• Interest rates: When rates are low, investors accept higher earnings multiples. A CAPE of 30× in a 2% interest-rate environment might be justified. In a 5% environment, it is too high. Shiller's framework does not adjust for this.
• Economic growth: CAPE does not vary with long-term real growth expectations. If the economy accelerates, multiples should expand.
• Technological change: A permanent improvement in productivity (like the internet) justifies higher multiples. CAPE struggles to distinguish between a cyclical bubble and a structural shift.
• Investor risk appetite: When investors are fearful, multiples compress. When they are complacent, multiples expand. CAPE does not capture sentiment shifts.

The timing problem in action:

• 1995–1999: CAPE rose from 20× to 44×. It signaled overvaluation, but the market continued to soar. An investor who sold in 1995 and stayed in cash missed four years of 30%+ returns.
• 2008–2009: CAPE fell from 27× to 13×. The market bottomed in March 2009, but CAPE was still in the mid-teens in mid-2009. An investor using CAPE as a buy signal would have waited several more months to deploy capital, missing some of the strongest returns.

This is not a flaw unique to CAPE. All valuation metrics struggle with timing. But it is important to understand: CAPE is not a market-timing tool. It is a regime indicator. It tells you whether valuations are at an extreme (bubble or crash), not when the extreme will end.

The Structural Problem: CAPE Misses Permanent Changes

CAPE faces a deeper conceptual problem: it assumes that the long-term earnings power of the market is stable. But the economy changes. Structural shifts happen.

The 1990s example:

The internet and computing revolution permanently increased the productivity and profit potential of the economy. A company that could reach millions of customers with negligible marginal costs (like software or online retail) could achieve much higher profit margins than legacy businesses. This was not temporary. It was structural.

CAPE at 40× in 1999 looked expensive by historical standards, and it was. But it was not as absurdly overpriced as it appeared, because the composition of the market had shifted to higher-margin, faster-growing businesses. The fair CAPE for the market might have risen to 25–30× just from the structural shift, before any bubble premium was added.

When the bubble burst, investors conflated the structural overvaluation with the cyclical overvaluation. They threw out the internet and the tech revolution along with the speculative excesses. That was a mistake. Some investors who bought the dip in late 2000 and held for 10 years saw exceptional returns as the structural case played out.

The 2010s example:

During the 2010s, the financial sector fell out of favor after the crisis, and technology and consumer discretionary stocks rose. This sector rotation permanently changed the composition of the S&P 500. The average profit margin, return on capital, and growth rate of the market increased. CAPE remained flat or fell during much of the 2010s, even as valuations were actually rising for the new mix of stocks.

By 2015–2020, CAPE signaled fair value (around 25–28×), but the market was arguably more expensive than the CAPE suggested, because the marginal company in the index was higher-margin and faster-growing than before.

CAPE for Individual Stocks: When It Fails

CAPE is designed for market indices, where you can average 10 years of earnings over hundreds of companies. For individual stocks, CAPE is often useless.

Why?

• Business model shifts: A company might have earned $2 per share for a decade, then shift to a new, more profitable business model. The 10-year average is not representative.
• Acquisitions: A company that grew via acquisition has a history that includes both organic earnings and acquired earnings. Averaging them is misleading.
• Cyclical vs secular change: Is the company's earnings down because of a cycle downturn, or because of secular decline? For an individual stock, the distinction matters more, and a 10-year average might obscure it.
• Margin expansion: A company might have invested heavily for 5 years (suppressing margins) and then reaped the benefits. The average masks both the sacrifice and the payoff.

For individual stocks, normalized earnings (adjusted for the specific cycle and for one-time items) are more useful than a 10-year average. Or use forward earnings, provided you understand the forecast risk.

CAPE and Interest Rates: A Critical Adjustment

One of CAPE's greatest oversights is ignoring interest rates. Valuations should rise when risk-free rates fall and fall when rates rise. A CAPE of 30× is much less worrying in a world where 10-year Treasuries yield 1.5% than in a world where they yield 5%.

Some researchers have tried to adjust CAPE for interest rates, using a formula like:

Adjusted CAPE = CAPE × (Current 10-Year Treasury Yield) ÷ (Historical Average Treasury Yield)

This makes intuitive sense: if rates fall, you should be willing to pay more for a given earning (because the alternative—bonds—yields less). The adjustment is controversial, but it captures a real economic truth that plain CAPE misses.

If you use CAPE, at least be aware of the interest-rate environment. A CAPE of 30× in a low-rate world is more defensible than the same CAPE in a high-rate world.

Real-World Example: CAPE in 2023–2024

In 2023–2024, CAPE was hovering around 32–35×, above the long-term average and near bubble levels. What did this tell you?

The CAPE signal: The market is expensive. Expect lower returns over the next 10 years.

The reality: The signal was correct in a statistical sense—markets that start expensive do tend to have lower subsequent returns. But the signal did not say when the correction would come or how much lower the market would go.

Some investors sold or reduced exposure in 2023, fearing a major crash. Others doubled down on the companies driving the CAPE expansion (the "Magnificent Seven": Apple, Microsoft, Google, Amazon, Netflix, Tesla, Nvidia). Both strategies could have made money, depending on the path of interest rates and growth expectations.

The point: CAPE says "be cautious," but it does not say "sell" or "buy." It should influence your allocation and your margin-of-safety requirements, but not your timing.

When CAPE Works: Macro Allocation

CAPE is most useful when you are making a high-level allocation decision, not a stock-picking decision.

Example questions:

• "Should I be 70% stocks or 50% stocks?" CAPE can inform this. If CAPE is 35× (bubble), 50% might be prudent. If CAPE is 15× (crash), 70% might be appropriate.
• "Should I shift from domestic to international stocks?" If the S&P 500 CAPE is 32× and emerging-market CAPE is 15×, the case for diversification is stronger.
• "Am I early or late in the market cycle?" A CAPE that is still rising suggests valuations are expanding; a CAPE that is elevated but flat suggests valuations have stabilized.

For these macro questions, CAPE is a useful input. For stock picking and market timing, it is less helpful.

FAQ

Q: Is CAPE above 30× a sell signal? A: Not necessarily. It is a caution signal. Markets have stayed at 30+× CAPE for years before correcting. Use CAPE to inform your asset allocation and margin of safety, not to time exits.

Q: How does CAPE account for inflation? A: All historical earnings are converted to today's dollars using CPI. This ensures that earnings from 2015 are not compared to current prices in nominal terms.

Q: Should I use trailing or forward P/E if CAPE is elevated? A: Both. If trailing P/E is low but CAPE is high, it means the market expects large earnings growth. Make sure that growth is realistic before betting on it.

Q: Can CAPE predict 1-year or 5-year returns? A: Poorly. CAPE correlates with 10-year returns (high CAPE → lower returns over 10 years), but it does not predict shorter-term moves. The market can stay expensive and go higher, or it can crash with little warning.

Q: Why does CAPE ignore interest rates? A: It is a design flaw. Shiller's framework is based on the idea that market valuations are mean-reverting around a stable trend. But that trend is not stable—it shifts with rates, inflation expectations, and growth expectations.

Q: Is CAPE useful for individual stocks? A: Not really. Use industry-specific normalized earnings instead. CAPE works for broad indices because of the law of large numbers; for individual stocks, the business model and cycle are unique.

Related Concepts

• Cyclically adjusted earnings: Earnings averaged over a business cycle (typically 10 years) to smooth out temporary peaks and troughs.
• Shiller, Robert: Nobel Prize–winning economist known for research on behavioral finance and stock-market bubbles. CAPE is his most famous contribution to investing.
• Mean reversion: The statistical tendency for prices to revert to long-term averages. CAPE is based on the assumption that valuations mean-revert.
• Real earnings: Earnings adjusted for inflation, usually using CPI.
• Fair value CAPE: The historical average CAPE (roughly 16–17 for the S&P 500), around which valuations oscillate over time.

Summary

The Shiller CAPE ratio solves a real problem: standard P/E ratios are distorted by the business cycle. By averaging 10 years of inflation-adjusted earnings, CAPE gives a better picture of whether the market is fundamentally expensive or cheap.

CAPE is excellent at identifying major bubbles and crashes, but poor at timing within a valuation regime. It also ignores interest rates and misses structural shifts in the economy. For individual stocks, CAPE is not useful; use business-model-specific normalized earnings instead.

For macro-level decisions—how much to allocate to stocks, whether to overweight or underweight equities relative to bonds—CAPE is a valuable input. But for stock picking and market timing, treat it as one signal among many. A high CAPE should increase your margin-of-safety requirements and lower your return expectations, but it should not paralyze you or force you to be out of the market.

In the next article, we explore the earnings yield, which inverts the P/E ratio and lets you compare stocks to bonds on a more apples-to-apples basis.

Next

→ Earnings yield and the bond comparison