The Use And Misuse Of The CAPE Ratio

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This article originally appeared on ETF.COM here.

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The Shiller cyclically adjusted (for inflation) price-to-earnings ratio – referred to as the CAPE 10 because it averages the last 10 years’ earnings and adjusts them for inflation – is a metric used by many to determine whether the market is undervalued, fairly valued or overvalued.

Employing a 10-year average for earnings, instead of the most current 12-month earnings, was first suggested by legendary value investors Benjamin Graham and David Dodd.

Birth of the CAPE

In their classic 1934 book “Security Analysis,” Graham and Dodd noted that traditionally reported price-to-earnings ratios can vary considerably because earnings are strongly influenced by the business cycle. To control for the cyclical effects, Graham and Dodd recommended dividing price by a multiyear average of earnings and suggested periods of five, seven or 10 years.

Then, in a 1988 paper, economists John Campbell and future Nobel Prize-winner Robert Shiller, using a 10-year average, concluded that a long-term average does provide information in terms of future returns. This gave further credibility to the concept, and led to the popular use of the CAPE 10.

However, as Graham and Dodd noted, there’s really nothing special about using the 10-year average. Other time horizons also provide information on future returns.

For example, research on the expected equity premium, including Aswath Damodaran’s paper “Equity Risk Premiums (ERP): Determinants, Estimation and Implications,” has found that the best predictor of future equity returns is current valuations – whether using measures such as the earnings yield (E/P) derived from the Shiller CAPE 10 (or for that matter, the CAPE 7, 8 or 9) or the current E/P – not historical returns.

A review of the evidence led Damodaran to conclude: “Equity risk premiums can change quickly and by large amounts even in mature equity markets. Consequently, I have forsaken my practice of staying with a fixed equity risk premium for mature markets, and I now vary it year to year, and even on an intra-year basis, if conditions warrant.”

Forecasts of returns are important

It is impossible to build an investment plan without estimating the return to stocks (as well as to bonds and any alternative investments). One reason is that the estimate of returns determines your need to take risk – how high an allocation to equities and other risky assets you will need to reach your goal.

If your estimate is too high, it’s likely you won’t have sufficient assets to reach your retirement goal. If it’s too low, it could lead you to allocate more to equities, which means taking more risk than necessary. Alternatively, it could lead you to lower your goal, save more or plan on working longer.

Unfortunately, there are many mistakes made when looking at the historical record of the CAPE 10 in terms of its forecasting accuracy. The most common error is to cite how much error there is in the forecast – the R-squared value is about 40%.

In a November 2012 paper, “An Old Friend: The Stock Market’s Shiller P/E,” Cliff Asness, of AQR Capital Management, found that the Shiller CAPE 10 provides valuable information. Specifically, he found 10-year-forward average real returns drop nearly monotonically as starting Shiller P/Es increase.

Read the full article here by Larry Swedroe, Advisor Perspectives

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