There is the price-earnings ratio and there is the cyclically adjusted price-earnings, or CAPE, ratio. In wrapping up chapter five of “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” author Sven Carlin focused on CAPE as the ninth and final tool for business valuations.
Tool 9: The CAPE ratio
In leading off, Carlin argued, “Yale’s professor Robert Shiller didn’t get the so-called Nobel Prize for nothing, the CAPE ratio really works. It gives you a clue on the long-term trend around a security or sector and is an essential metric to use for long term investing purposes and value calculations.”
He followed up by noting that Benjamin Graham began using 10-year averages in the 1930s, so Shiller’s idea was not new, but he did expand usage of the idea and provided academic confirmation of it.
As we know, price-earnings is based on a single year’s worth of data and can be skewed (or even manipulated) by one-time events or economic circumstances. To overcome the volatility of single-year earnings, John Campbell and Shiller proposed in a 1988 paper that investors use CAPE, which averages earnings over a full decade. This would usually cover both an up cycle and down cycle.
They saw two important benefits:
- CAPE is less volatile because it uses long-term earnings, rather than just one year.
- Long-term earnings better represent real business performance. CAPE shows when the market is cheap or expensive—from a value perspective. In a recession, earnings go down, leading the price-earnings ratio to spike higher despite little or no change in the underlying business. On the other hand, the CAPE ratio is less volatile because the earnings for any single year have only a 10% influence on it.
Carlin produced this chart, comparing price-earnings and CAPE between Jan. 1, 1980 and Sept. 1, 2016. Note how the price-earnings ratio spiked to more than 60 in late 2008 and early 2009:
According to Carlin, many investors dislike the CAPE ratio because it sometimes brings bad news. Specifically, it eliminates short-term cyclicality, making it an effective tool for assessing whether the market is overvalued or undervalued. More specifically, again, at the time of writing in late 2017, the CAPE was very high. He noted the ratio was higher only once before, and that was in the leadup to the dot-com crash in 2000. What was even more concerning was the fact the CAPE for the 1929 bull market was lower than it was at the end of 2017. Carlin wrote, “Unfortunately, we all know how both situations ended for investors.”
This chart from the book shows the CAPE ratio from 1881 to Sept. 1, 2016:
The CAPE most recently peaked in January 2018 at 33.31 and has since declined to 29.1 at the close of trading on Jan. 18, 2019. That latter ratio is still quite high, however, given the historical average of 16.8. Thus, the market remains “severely” overvalued.
That’s not just a bit of market trivia. There is a relationship between the CAPE ratio and future stock market returns. When the CAPE is low, investors can expect high returns in the future. When the CAPE is high, investors should brace for lower returns. As Carlin noted, “10-year yearly 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.”
To take advantage of the CAPE ratio, investors can take two actions:
- Rebalance across sectors and countries.
- Find individual stocks that are doing well or growing, while in a temporarily weak sector.
Rebalancing becomes necessary as various sectors move through their cycles, and Carlin sees in this an opportunity: “Long-term value investors can reap huge rewards by carefully rebalancing between cheap and expensive sectors over time. Barclays’ and Robert Shiller’s research has shown that 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.”
Looking at countries, rebalancing will be driven by political and economic changes. CAPE ratios will be high in countries that have had looser monetary policies, thus inflating the money supply and opening the door to asset bubbles. On the other hand, countries that have had only modest stimulation, and may have had a political or economic crisis, will have low CAPE ratio. Value investors can find an edge by investing in countries with sound but low ratios, and then holding on until it rises.
The same strategy holds for individual stocks. This means investing in stocks that are in temporarily weak sectors but still showing sound fundamentals. Carlin added that when assessing individual stocks, investors should take account of the cyclical impact of sectors and countries. For example, investors can check how much earnings fell in a previous correction and apply a similar earnings loss to evaluations of the decade ahead.
Carlin concluded with these words of praise: “The CAPE ratio is a great tool that shows whether the market is overvalued or undervalued. It is an amazing tool that certainly helps in determining a value range for any stocks, be it by looking at the situation in the general market, sector or stock.”
CAPE is also known as Shiller PE, and can be followed on the GuruFocus website, where it is updated every 10 minutes. This was where it stood at the close of trading on Jan. 18:
The Shiller PE ratio also is available for individual stocks. Choose a stock, go to the Interactive Chart, then from the menu on the left side of the screen click on "Valuation & Quality" and, finally, click in the box adjacent to Shiller PE Ratio.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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