Jargon Busting: Cyclically adjusted price-to-earnings ratio

Jargon Busting: Cyclically adjusted price-to-earnings ratio

The cyclically adjusted price-to-earnings (Cape) ratio has risen in prominence in recent years.

The Cape is typically allied with the argument that equities in general, and the US market in particular, are expensive. It is a weapon of choice for bears.

Cape is a simple concept but is also a misnomer. More accurately, it would be the “price to inflation-adjusted average earnings ratio”, but that does not make nearly as nice an acronym.

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The concept was originally articulated by Columbia Business School professors Benjamin Graham and David Dodd back in 1934, but has been popularised by the multifarious and Nobel prize-winning economist Robert Sheller.

So much so that it is now frequently just called the ‘Sheller p/e’ ratio. Its purpose is to try to improve on the basic price-to-earnings ratio as a ready-reckoner to show how expensive an asset is. It can be used for any equity or equity index, but here we will stick to the S&P 500 index.

Company earnings, so the theory goes, ebb and flow with the economy and thus mean little in isolation. They become more meaningful if you can iron out the fluctuations by taking an average.

The idea is to be able to “look through the cycle”. One problem with this is that no one has much of an idea of the length of an economic cycle, so it is easy and convenient to take it as being 10 years.

To calculate the Cape, we take the total earnings made by the market during each discrete year, then adjust it by inflation into present-day prices so that they are comparable.

Having obtained the inflation-adjusted earnings for each of the past 10 years, we average these and divide the current level of the index by the answer. Hey presto, we have a Shiller p/e.

The process has a lot going for it. By using rolling 10-year periods it is consistent and relatively immune to short-term noise. It looks, therefore, as if the Cape should be a big improvement over the single-year, and more volatile, p/e ratio.

But the Cape is what it is: a smoothed p/e ratio, not a buy or sell indicator. It tells us where one valuation measure stands relative to its own history, not whether the market is going to go up or down.

Useful as the Cape is, it has its drawbacks.

First among equals is that it is backwards-looking – it does not tell us about what analysts expect to happen in the future.

Second, it can take a very long time to come back to its long-term average once it has deviated widely – up to 20 years, in fact.

So although the bears’ argument runs that US equities are expensive at the moment because the Shiller p/e is 60 per cent or so above its long-term average and what goes up must come down, it may take a decade or more for this to happen. Or it may happen much sooner. Or it may never happen at all.