Is the U.S. stock market cheap or overvalued? There are many ways to measure the market’s value. But a popular metric is the Cyclically Adjusted Price-Earnings ratio, or CAPE. The CAPE ratio, also known as the P/E 10 ratio, divides the price of the S&P500® Index by the average inflation-adjusted reported earnings from the previous 10 years.
Dating back to the 19th century, the CAPE ratio has maintained a long-term median of about 16. Readings above this level can indicate the market is overvalued and bound to revert downward toward the mean, while readings below can signal an undervalued market with room to rise.
But there’s reason to question the messaging from CAPE readings, says Liz Ann Sonders, Charles Schwab’s Chief Investment Strategist. She says several shortcomings with the way the ratio is constructed can create stilted comparisons:
- The average U.S. business cycle has been about six years, while CAPE looks back 10 years. In addition, CAPE uses reported (not operating) earnings and includes one-time write-offs. These accounting practices contribute to the CAPE reflecting nonrecurring items. The net effect is that the 10-year CAPE overestimates “true” average earnings during a contraction and underestimates them during an expansion.
- The CAPE’s inflation adjustment does not account for ongoing changes in the way the consumer price index (CPI) is calculated, creating apples-to-oranges comparisons.
- Accounting standards have changed significantly over time, reducing the reliability of earlier earnings figures.
Liz Ann also cautions that a high CAPE reading doesn’t mean a correction is necessarily imminent. “If you follow the CAPE as a valuation tool, you have to be mindful of the simple fact that the stock market can become ‘overvalued’ and stay that way for quite some time,” she says.
But while it falls short in anticipating short-term market moves, the CAPE can be a good tool for judging whether long-term returns for the stock market will be above or below average. Investors may want to adjust their return expectations downward for stocks and ensure their portfolios are adequately diversified when market measures such as the CAPE are running above historically high levels.