Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 239

The CAPE hanging over share markets

The long-anticipated fall in US share markets and return of volatility finally arrived this week, with the S&P 500 down 4.1% on Monday 5 February 2018 after a 2% fall the previous Friday. Following this lead, the S&P/ASX200 fell 2% then 3.5%, and the headlines screamed of panic selling and a wipe out of billions of dollars of wealth.

But these movements always require a context. The S&P 500 was up 5.6% in January 2018 alone, hitting all-time highs. Long-term investment plans should expect stock markets to move like this regularly.

What matters more is where the market is headed for the long term, and whether it offers value compared with historical levels.

Two weeks ago, Robert Shiller, 2013 Nobel laureate in Economic Sciences, and co-inventor of the CAPE measure, was calling the US the “world’s priciest stock market” because the CAPE ratio was higher than every other country measured.

Development of the CAPE ratio

Thirty years ago, in February 1988, Robert Shiller and John Campbell presented a paper to NBER (National Bureau of Economic Research) that led to the cyclically-adjusted price-to-earnings (CAPE) ratio. The CAPE ratio is the real (inflation-adjusted) price of a share divided by a ten-year average of real earnings per share. It's an alternative to the more common P/E ratio.

Why ten years? Says Shiller:

“Ownership of stock represents a long-term claim on a company’s earnings, which the company can pay to the owners of shares as dividends or reinvest to provide the shareholders more dividends in the future. A share in a company is not just a claim on next year’s earnings, or on earnings the year after that. Successful companies last for decades, even centuries.”

Earnings can be volatile from year to year, but research indicates there is mean reversion in earnings, which means there’s value in using long-term averages.

The CAPE ratio reached an all-time high during the dot-com bubble. It also reached a historically high level again during the GFC up to 2007. Today, Barclays Bank in London compiles the CAPE ratios for 26 countries using Robert Shiller as a consultant.

As shown below, the historical mean of the CAPE for US markets is 16.8. At the close of 5 February, it stood at 32, or 90% higher (the regular P/E ratio has an historical mean of 16 and stood at 25).

Shiller and Campbell found that the lower the CAPE, the higher the investors' likely return from equities over the following 20 years. A comparison of CAPE values might assist in identifying the best markets for future equity returns.

Is the US market overpriced?

Two weeks ago, writing in Project Syndicate, Shiller expressed a concern that the CAPE ratio is at an historical high in the US and that it is higher than for any other country that it is measured for. At the end of 2017, the CAPE ratios for five major economies were: US 30.9, Australia 21.4, China 24.6, Japan 29.2, and UK 18.6.

While this might indicate some cause for concern, especially in the US, a high CAPE ratio need not mean that the market is necessarily overpriced.

Contrarian Geoffrey Caveney finds a reason for why the US CAPE ratio is now around its historic highs (it was only higher in the late 90s dot-com bubble):

“However, this is misleading right now because the CAPE ratio's 10-year back period begins with the Great Recession in 2007. So the 10-year earnings are abnormally low, due to the effect of 2007-2009 on the 10-year average. As the recession years ‘roll off’ the 10-year back period, the 10-year average earnings will increase, and stock prices can rise without making the Shiller CAPE ratio rise excessively.”

Diversify rather than justify

Even when using his own measure, Shiller cautions against being too sure of the reason it is high:

“… the mystery of what’s driving the US stock market higher than all others, [is] not the “Trump effect,” or the effect of the recent cut in the US corporate tax rate. After all, the US has pretty much had the world’s highest CAPE ratio ever since President Barack Obama’s second term began in 2013. Nor is extrapolation of rapid earnings growth a significant factor, given that the latest real earnings per share for the S&P index are only 6% above their peak about ten years earlier, before the 2008 financial crisis erupted.”

“The truth is that it is impossible to pin down the full cause of the high price of the US stock market. The lack of any clear justification for its high CAPE ratio should remind all investors of the importance of diversification, and that the overall US stock market should not be given too much weight in a portfolio.”

However, if US selloffs continue to be replicated in other markets, the US may retain its relative high, but hopefully not its historic high.

As tempting as it would be to justify investing against proven trends, country diversification could well be one simple response that is also prudent in a well-diversified portfolio.

(For an interactive analysis of CAPE ratios over time and for many countries, see this link).

 

Vinay Kolhatkar is Assistant Editor at Cuffelinks. This article is general information and does not consider the circumstances of any investor.

 

RELATED ARTICLES

Why it's a frothy market but not a bubble

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

SMSF strategies

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Superannuation

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Planning

How to avoid inheritance fights

Inspired by the papal conclave, this explores how families can avoid post-death drama through honest conversations, better planning, and trial runs - so there are no surprises when it really matters.

Superannuation

Super contribution splitting

Super contribution splitting allows couples to divide before-tax contributions to super between spouses, maximizing savings. It’s not for everyone, but in the right circumstances, it can be a smart strategy worth exploring.

Economy

Trump vs Powell: Who will blink first?

The US economy faces an unprecedented clash in leadership styles, but the President and Fed Chair could both take a lesson from the other. Not least because the fiscal and monetary authorities need to work together.

Gold

Credit cuts, rising risks, and the case for gold

Shares trade at steep valuations despite higher risks of a recession. Amid doubts that a 60/40 portfolio can still provide enough protection through times of market stress, gold's record shines bright.

Investment strategies

Buffett acolyte warns passive investors of mediocre future returns

While Chris Bloomstan doesn't have the track record of his hero, it's impressive nonetheless. And he's recently warned that today has uncanny resemblances to the 1990s tech bubble and US returns are likely to be disappointing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.