This article is the first in a new mini-series, Eight Temptations of Market Lore, which explores popular investing rules of thumb and the pitfalls that can accompany them.
Before there were seven deadly sins, there were eight temptations. In the fourth century, the monk Evagrius Ponticus listed eight thoughts that lead people astray. Two centuries later, they evolved into the seven deadly sins.
Markets have their own temptations. This series covers eight popular shortcuts that investors reach for because they are easy to use. They are not naive rules. Many were developed by serious thinkers and hold real insight. But each rests on an assumption that is easy to miss, and costly when it fails.
Shiller’s famous CAPE ratio
Robert Shiller’s book Irrational Exuberance made the cyclically adjusted price-to-earnings ratio, or CAPE, famous.
CAPE fixes a problem with the ordinary PE ratio. A single year of earnings can give the wrong signal about value, because profits swing with booms and busts. CAPE instead divides the share price by the average of the past ten years of inflation-adjusted earnings to cover a full business cycle. The idea came from Benjamin Graham, who in 1934 advised averaging earnings over seven to ten years.
Shiller’s timing was uncanny. His book was published in March 2000, the month the Nasdaq peaked. CAPE had just hit a record of about 44, and US shares went on to suffer a lost decade. In 2013, he shared the Nobel Prize in economics. With a track record like that, it is easy to trust his measure. I have been tempted by it myself.
Today the S&P 500’s CAPE sits near 41. That is higher than before the 1929 crash, and second only to the dot-com peak. On that measure, US shares look very expensive.
Source: Robert Shiller
But the ten-year average that solves one problem creates another. It assumes the past decade is a fair guide to normal profits. If today’s earnings sit well above that average, CAPE treats the gap as a boom that will fade.
The gap can close in two ways. Margins can fall back, and CAPE is proved right. Or margins stay high until ten years of higher earnings pass through the average, and CAPE falls without prices falling. But if margins keep rising, the gap never closes, and CAPE keeps overstating how expensive shares are.
Margins have structurally shifted
Source: FactSet, Robert Shiller
Since 2005, the S&P 500’s operating (EBIT) margin has risen from about 14% to just under 22%, and CAPE has moved closely with it. The two fell together in the GFC and climbed together through the 2010s. Today they sit together at their highs. Rather than returning to its long-run average, CAPE has followed profitability. In other words, the market looks expensive on CAPE partly because it has become more profitable.
For investors who followed CAPE, this shift was costly. As margins rose, the ten-year average lagged. The market looked expensive year after year, so CAPE signalled low returns for a decade that never came. Earnings kept compounding instead.
The exception was 2021. CAPE surged to about 38, while margins only recovered to their pre-COVID level of about 17%. For once, prices had run ahead of profits. It was a smaller echo of the 1999 tech boom, with heavy speculation in unprofitable companies, SPACs and meme stocks. CAPE and prices fell back in 2022, when the S&P 500 dropped about 19%.
Why have margins risen? Much of it reflects the index’s changing mix. Technology and tech-related companies make up close to half of the S&P 500, against about a fifth two decades ago. These businesses earn higher margins than the typical company.
The best of them have also shown a rare ability to reinvent themselves. Microsoft moved from selling software licences to renting cloud computing. Amazon began by selling books online, then sold almost everything, before building a cloud business and an advertising arm. Netflix went from posting DVDs to streaming, then to making its own shows, and has since added advertising. Each pivot opened a large new source of growth, and is one reason high margins may prove more durable than CAPE assumes.
Conclusion
CAPE is tempting because it reduces valuation to a single number. But that number cannot tell you whether the businesses behind the earnings have changed. Twenty years ago, financial companies were one of the largest parts of the S&P 500. Today the index is led by technology businesses that earn higher margins.
So read CAPE alongside margins. The question to ask is not “Is CAPE high?” but “Is it high because profits are, or because prices are?”
Jason Teh is a financial commentator and portfolio manager. This article is general in nature and does not constitute or convey personal financial advice. It has been prepared without consideration of anyone’s financial situation, needs, or financial objectives. Before acting on the areas discussed and contained herein, you should consider whether it is appropriate for you and whether you need to seek professional advice.