How The CAPE Ratio Can Give You An Investing Edge

March 10, 2017

How The CAPE Ratio Can Give You An Investing Edge

  • The CAPE ratio shows when something is cheap or expensive and is much more precise than the PE ratio.
  • The S&P 500 is 74% overvalued and will result in negative 10-year returns according to the CAPE ratio and history.
  • However, there is plenty that can be done to improve your returns.

Introduction

Whether you’re a long-term investor or a trader, something that gives you a clue on the long-term trend around a security or sector is always very useful. Such a ratio was developed by Yale professor Robert Shiller and he didn’t get a Nobel prize for nothing, the CAPE ratio really works.

Today, I’ll describe it, show how it can be used, and analyze its past performance.

The Cyclically Adjusted Price Earnings Ratio or Shiller PE Ratio (CAPE)

The main difference between the CAPE ratio and a standard price earnings (PE) ratio is that the PE relies on a single year of income information. Such information is usually skewed by one-off events like asset sales or impairments, or by the state of the economy. After eight years of economic expansion many have forgotten that the economy is a cyclical beast.

To improve the PE ratio, Campbell and Shiller (1988) developed the CAPE ratio which uses average earnings over a ten year period to eliminate the usual volatility in earnings and cyclical effects.


Figure 1: Monthly S&P 500 CAPE and PE ratios since January 1, 1980. Source: Multpl, annotated by the author.

Two things are immediately clear from the chart above. The first is that the CAPE ratio is much less volatile than the PE ratio as it uses long term average earnings. The second is that as it uses long term earnings that represent real business performance. The CAPE shows when a market is cheap (green circles) and when a market is expensive (red arrows). When earnings decline in a recession, the standard PE ratio spikes while the CAPE ratio declines as it takes a bit of time for average earnings to decline.

Buying an asset when the CAPE ratio is low gives you a margin of safety if there isn’t a structural problem with the asset, sector or market.

Nobody Likes The CAPE Ratio Because It Brings Bad News

As the CAPE ratio shows how the real earnings behind an economy are doing and eliminates the impact of short term bubbles, it’s a great tool to assess whether the market is overvalued or undervalued. Only two times in history has the CAPE ratio been higher than it currently is, in 1929 and during the dotcom bubble at the end of the 1990s. Unfortunately, we all know how both situations ended for investors.


Figure 2: Historical S&P 500 CAPE ratio. Source: Multpl.

As a CAPE ratio of 16.73 is the historical average for stocks, the current CAPE of 29.18 indicates the market is overvalued by just 74%. By plotting 10-year returns to the CAPE ratio, we see that current main stream index investors are in for a nasty surprise in the next decade. 10-year returns have always been below 5% when the CAPE was above 20, below 1% when the CAPE was above 25, and negative when the CAPE was above 28 (lower yellow curve shows 10-year returns, higher yellow curve shows 15 year returns).


Figure 3: Expect negative 10-year returns and miserable 15-year returns from the current market. Source: Star Capital.

Using the CAPE and price to book value as a forecast for the S&P 500, Star Capital’s Norbert Keimling tells us that the S&P should be around 4,400 points by 2031. This would imply a yearly return of only 4.2%. In the worst-case scenario, the S&P 500 could hit 800 points while a probable negative scenario would see it at the same level as it is today in 2031. If the market remains as exuberant as it is now for the next 15 years, we could see the S&P 500 pass 6,000 or even reach 9,000 points. This might look like a broad range but it’s another characteristic of the CAPE ratio, it tells you the risk reward ratio for any kind of investment.

If you aren’t satisfied with 4.2% per year in the next 15 years, don’t despair as there is plenty that can be done to improve your returns.

A Few Things That Can Be Done

Rebalance Across Sectors

During time, CAPE ratios vary enormously across sectors as sector profitability is impacted by its own cyclical patterns. For example, one sector that is currently under pressure and has low current earnings but stable historical earnings, is the fertilizer sector. Investing now would give you a low CAPE investment and would probably overperform in the future as the cycle turns due to the low current fertilizer prices and low investments. Similarly, all sectors experience wild swings in sentiment and, consequently, in their CAPE ratios.


Figure 4: S&P 500 CAPE ratios by sector. Source: BFLJ Award.

According to Barclays and Robert Shiller’s research, rebalancing an S&P 500 portfolio according to relative sector CAPE ratios would have outperformed the S&P 500 by 4 percentage points per year since the CAPE ratio was introduced in 1988.


Figure 5: S&P 500 is easily outperformed by using a relative CAPE ratio rebalancing strategy. Source: BFLJ Award.

If you still want to search not only for better relative CAPE ratios per sector, but for real bargains with low CAPE ratios, then you have to go global.

Go Global

High CAPE ratios are mostly found in countries that have had strong easing policies that inflated the money supply resulting in an asset bubble. Countries that didn’t stimulate too much, and perhaps had a political or economic crisis, have CAPE ratios that are sometimes even in the single digits.


Figure 6: Global CAPE ratios. Source: Star Capital.

Look at individual stocks and add the growth factor.

If you want even better returns than you can get from rebalancing the S&P 500 and going global, you have to look at individual stocks that are in a temporarily weak sector but are still doing well and perhaps are even growing. The growth doesn’t have to be coming from earnings as the sector is in trouble, but could come from acquisitions as the best acquisitions are made when assets are cheap.

Conclusion

I don’t like models or rules but I believe that such models as the CAPE ratio, especially if backed by history, can be very helpful in creating a strong low risk high reward portfolio that can easily beat the S&P 500. The CAPE ratio is just one of many tools that can be used, but it’s extremely important as historical analysis shows that it has been pretty consistent in determining future returns.

A variable that isn’t grasped by the CAPE is growth. However, when you find growth in combination with a low sector CAPE, you know you are onto something. Such situations aren’t that difficult to find in emerging markets. India is a great example.