The CAPE Ratio Debate: A New Perspective on Stock Market Valuation

In the world of investment analysis, established indicators wield significant influence over market perceptions. One such measure—the cyclically adjusted price/earnings ratio (CAPE)—has garnered attention for suggesting that the stock market, specifically the S&P 500, is experiencing unparalleled overvaluation since 1871, rivaling only the bubble of the early 2000s. However, a recent study proposes an alternative viewpoint, challenging the traditional CAPE ratio and asserting it may overstate the market’s true worth. This development warrants serious consideration by investors seeking to understand the current market dynamics.

Understanding CAPE

The traditional CAPE ratio, developed by Yale University professor and Nobel laureate Robert Shiller, gauges the relative price of stocks against long-term earnings, calculated by dividing the current S&P 500 index level by average inflation-adjusted earnings per share over the trailing ten years. This method ostensibly smooths out fluctuations due to economic cycles, allowing analysts to grasp corporate America’s long-term earnings potential. However, a new study promises to refine this approach, aiming to provide a more truthful assessment of valuation by addressing limitations within the CAPE.

A New Dawn: Current Constituents CAPE (CC-CAPE)

The research conducted by Trent Commins, Ted Hsu, and Seanna Kim at Research Affiliates introduces a variant called the Current Constituents CAPE, or CC-CAPE. Their approach addresses a significant flaw identified in the traditional methodology: it relies on outdated earnings data from companies that have been removed from the S&P 500. When a poorly performing stock exits the index, its depressed earnings continue to weigh down the CAPE ratio for an entire decade before being phased out, while the incoming stock often represents a robust economic position.

To rectify this bias, the authors of the study developed a formula that examines only the earnings of the S&P 500’s current members. The CC-CAPE reflects the performance and profitability of stocks that are presently within the index, providing a more accurate reflection of market conditions. Their findings reveal that this revised CAPE ratio has demonstrated superior predictive capabilities for subsequent stock market returns over both short and long-term periods compared to its predecessor.

The CAPE Spread: Gauging Market Sentiment

One of the noteworthy contributions of the study is the introduction of the CAPE Spread, which quantifies the difference between the CC-CAPE and the traditional CAPE. The authors suggest this metric can be used to indicate the level of irrational market sentiment. Historically, the CAPE Spread widens during times of significant index turnover and when new entrants exhibit inflated price-to-earnings ratios compared to the outgoing stocks.

The research shows that the current CAPE Spread is only slightly above average, particularly when juxtaposed against the record levels observed during the exuberant dot-com bubble. Given that there are fewer dramatic shifts in index composition and current stock fundamentals appear to be more stable and reasonable, there seems to be less irrational fervor propelling today’s market than in those tumultuous times.

Composite Indicator: Balancing Fundamentals and Sentiment

The researchers took their investigation a step further by developing a composite indicator that combines the traditional CAPE and CAPE Spread. This multifaceted approach encapsulates both fundamental valuations and market sentiment, resulting in a tool with even greater predictive accuracy than either version of the CAPE alone. Notably, this composite indicator proved to be more than twice as predictive of future returns at one-, three-, and five-year horizons as the traditional CAPE.

What This Means for Investors

The implications of this study are profound for investors attempting to navigate today’s market landscape. While the traditional CAPE distinctly flags stocks as overvalued, the CC-CAPE and the companion composite indicator suggest that the market is not plummeting headlong into a scenario of unbridled exuberance akin to the late 1990s. Instead, the current market may be characterized by cautious optimism, warranting a measured approach to equity investments.

In conclusion, as we reassess common investment indicators, it’s clear that while caution is warranted, it doesn’t need to translate into panic. Rather, we might be presented with a “flashing yellow” light—an invitation for prudence in equity risk-taking, instead of an outright red light warning to retreat from the market entirely. Investors must remain vigilant, grounded in traditional financial principles, while also embracing the evolution in analytical tools that provide deeper insight into an ever-changing landscape.