Shiller CAPE Ratio

The Shiller CAPE Ratio—Cyclically Adjusted Price-Earnings—divides the current stock market price by the ten-year average of inflation-adjusted earnings. Developed by Nobel laureate Robert Shiller, it smooths out the distortions of the business cycle, revealing whether the market is trading at historically rich or cheap valuations over the long run.

The problem with one-year earnings

A standard price-to-earnings ratio divides today’s price by the most recent year’s earnings. The trouble is that one year of earnings is highly cyclical. During a recession, profits crash and the P/E rockets; during a bull market, earnings surge and P/E drops—even if the market is overheated. A 9× P/E in a trough year might look cheap, but it means nothing if earnings collapse by half the next year.

Robert Shiller’s insight, which won him the Nobel Prize in 2013, was to use a decade of earnings instead. By averaging earnings across the full business cycle, you filter out the extremes. The ratio becomes a frame for asking whether the market is expensive or cheap relative to what it typically earns in normal times, not just this quarter.

Calculating CAPE

The formula is straightforward but requires historical data:

1. Take the closing price of an index (usually the S&P 500).
2. Divide by the average earnings per share of the past 10 years.
3. Adjust both for inflation, usually to the current year’s dollars.

Example: If the S&P 500 trades at 4,000, and the average inflation-adjusted earnings of the past decade is 200 per share, CAPE is 4,000 ÷ 200 = 20.

The ratio hinges on this ten-year window. Some years had bumper earnings; some had weak ones. The decade averages out the swings, giving a clearer picture of “normal” earning power.

Reading the ratio: historical context

Over the past 150 years, the Shiller CAPE has ranged from lows of 5–6 (1920s, 1980s) to highs of 40+ (the 2000 dot-com bubble). Most of the time, it sits between 15 and 25.

A CAPE of 15 signals the market is cheap by historical standards. A CAPE of 25 means expensive. A CAPE of 35+ is in bubble territory.

Crucially, Shiller himself is careful: CAPE is not a timing tool. A ratio of 30 doesn’t predict a crash next month; it suggests the market is overvalued on a ten-year horizon. The market can stay overvalued for years. The dot-com bubble peaked near 45 in 1999 and again in early 2000 before collapsing. But in 1996, CAPE was already 24, and the market still rose another three years.

Why smoothing matters

Without smoothing, a bear market that cuts earnings by half creates a misleading P/E. Suddenly the market looks cheaper on current earnings, but only because earnings temporarily evaporated. A decade-based ratio cuts through that noise by asking: are we pricing the business above what it averages over time?

During the 2008 financial crisis, single-year earnings collapsed. A traditional P/E became almost meaningless. But CAPE, which included eight years of solid pre-crisis profits, stayed in reasonable territory and correctly signalled that the crash was cyclical, not structural.

Inflation adjustment: why it matters

The second component of Shiller CAPE is inflation adjustment. An earnings figure from 1990 isn’t directly comparable to 2020 earnings unless both are in the same purchasing-power dollars. By adjusting to current dollars, the ratio compares apples to apples across decades.

This makes CAPE far superior to a simple price-to-earnings ratio for very long-term analysis. A market at 20× in the 1970s, when inflation was raging, was far cheaper than it appeared. A market at 20× in the 2010s, in low inflation, was genuinely expensive by historical standards.

The 2008–2009 bottom and subsequent rally

During the 2008 crisis, CAPE fell below 14—one of the lowest readings on record. That signalled deep value. By 2010, after the initial recovery, CAPE had risen to 20, and investors debated whether the market had already fully priced in the recovery. Over the next decade, the market tripled, even as CAPE rose past 30 by 2018.

This reveals both CAPE’s power and its limits. It told you the market was cheap in 2009 and expensive by 2017. But it didn’t tell you to sell in 2009 (the market kept rising for years) or that it would still deliver exceptional returns despite the high valuation. CAPE is for positioning, not timing.

The structural question: is 30 the new 25?

A running debate concerns whether CAPE thresholds have shifted. Tech companies, particularly those listed on the stock exchange, have higher profit margins and lower capital requirements than mid-20th-century industrials. Should tech-dominated indices trade at higher CAPE multiples?

Most academicians say no—valuation extremes are valuation extremes, no matter the era. But others note that the composition of the economy changes, and comparisons across 100 years can overweight quaint historical periods. This ambiguity doesn’t invalidate CAPE; it just cautions that a CAPE of 28 in 2024 might not predict doom the way a CAPE of 28 in 1929 did. Context still matters.

Using CAPE alongside other metrics

CAPE works best as one input among several. Pair it with earnings growth (are valuations high because growth is truly exceptional?), dividend yields (do shareholders get compensated for waiting?), and bond yields (what are risk-free rates?). A market at 28× CAPE but with 8% dividend yield and 10% earnings growth is richer than one at 18× with 2% yield and 1% growth.

Institutional investors use CAPE as a macro framework: overvalued markets may warrant a tilt toward value stocks or international markets. Overvalued doesn’t mean crash—it means lower future returns and higher downside risk.

Limitations

CAPE does not predict next-year returns. Period. A market at 30× CAPE has delivered negative, neutral, and strongly positive returns, depending on when you measured. The ratio is a long-term valuation anchor, not a crystal ball.

Also, CAPE is retrospective. It relies on reported earnings, which accounting standards have changed. Pension accounting, stock-option expensing, and revenue-recognition rules all shifted over the decades, making historical comparisons murkier.

For growth-heavy sectors, CAPE can lag. A software company trading at 40× earnings but growing 30% per year might deserve that premium, yet CAPE wouldn’t capture the growth story.

See also