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.
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.
A Changing Horizon
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. With that in mind, today we’ll analyze how changing the horizon can impact our view of the market’s valuation.
We’ll begin by looking at the current level of the CAPE 10. As of April 13, it was 26.3. This compares to a long-term (136-year) average of 16.7. The differential between the CAPE 10 today and its historical average has led many observers to conclude the market is overvalued and headed for a sharp decline. Jeremy Grantham and John Hussman have been among market gurus who, for the last four years or so, have been warning about an impending debacle as valuations eventually revert to their historical mean.
However, the market looks less overvalued if we change the horizon. Why would we consider a different horizon? First, as mentioned earlier, there is nothing magical about using 10 years to calculate the earnings average. Graham and Dodd even suggested using a five- or seven-year period. More importantly, in 2008, the earnings of the S&P 500 temporarily collapsed as a result of the financial crisis.
Note that in the following analysis, I’ve used the operating earnings of the S&P 500 as shown on NYU professor Aswath Damodaran’s website. The Shiller CAPE 10, however, uses “as reported,” or GAAP (generally accepted accounting principles), earnings. This distinction is important because operating earnings are generally higher, especially during recessions. With the Great Recession causing S&P 500 earnings to not recover to their 2007 level until 2010, we will look at CAPE ratios using earnings beginning in 2010. Thanks to the folks at AQR, we can examine both the CAPE 6 and CAPE 5 ratios using operating earnings as our measure.
CAPE Based On Operating Earnings
As of April 13, the current CAPE 6 was 18.7. Its average since 1960 was 15.5. That puts the CAPE 6 about 21% above its average over the past 56 years. Observe that when using GAAP earnings, the CAPE 6 is also lower than the current CAPE 10 of 26.3. It’s now at 22.7, or roughly 19% above its mean since 1960 of 19. The CAPE 5 was 18.5, again, as of April 13. Its average since 1960 was 15.7, placing it approximately 18% above its average. Using GAAP earnings, the current CAPE 5 would be 22.1, also about 18% above its mean of 18.1 since 1960.
While this still leaves the market looking somewhat highly priced compared with its historical averages, it no longer looks dramatically overvalued. That said, before you draw any conclusions, we need to consider the issues related to Shiller’s use of a 136-year historical mean.
The discussion that follows should highlight why I chose to look at the mean since 1960 instead of since 1880. In addition, some of the issues raised are based on changes made in just the last 20 years. When adjustments for them are made, the current high valuation (19% above the CAPE 6 mean since 1960 and 18% above the CAPE 5 mean) could disappear. Keep this in mind as you read the arguments.
