The S&P 500 Schiller CAPE Ratio, also known as the Cyclically Adjusted Price-Earnings Ratio, measures the S&P 500’s current price compared to the 10-year moving average of companies’ inflation-adjusted earnings. Invented by Yale economist Robert Shiller, the metric has become a popular measure for understanding long-term stock market valuations.
A higher CAPE ratio tends to signal lower returns in the future whereas a lower CAPE ratio signals higher returns, as the ratio reverts back to its mean. “The stock market is not the economy,” but worries of a recession have been weighing heavily on investors’ minds, although the stock market is holding up pretty well.
So what is the CAPE ratio saying after the S&P 500’s strong start this year?The S&P 500 Shiller CAPE Ratio has a pretty strong track record of predicting market declines. Out of 21 major market declines (defined as a 10% or greater drawdown in our white paper) since 1950, the CAPE Ratio has provided warnings for 10 of them by breaching its long-term average.
The chart below shows that relative peaks in the CAPE Ratio coincide with drawdowns for the S&P 500. Knowing the ratio is directly affected by declining equity prices, the question becomes: are we seeing a relative peak in valuations to start 2023?
From a historical perspective, the S&P 500 is currently relatively expensive…although this is dependent on your lookback period. The CAPE Ratio reached a relative peak of 30.99 just before the pandemic selloff, then climbed to 38.58, its second-highest value ever, near the end of 2021. With stocks rallying to start 2023 the CAPE has climbed to around 30.38, meaning prices for stocks in the S&P 500 are nearly par with their February 2020 levels.
But interpreting the CAPE’s relative level is not a straightforward exercise, like many things, it has to be analyzed and interpreted in context of many factors. Years ago, the well-regarded economist, John Maynard Keynes, warned, “the market can remain irrational a lot longer than you and I can remain solvent.
A longer-term lookback shows the degree to which valuations (purple) have risen over recent years as the market has marched higher (red line).
Using the CAPE along with other indicators can provide an idea where the market sits in terms of valuation and what future returns might look like.
While the CAPE ratio isn’t perfect in predicting crashes and short-term gyrations, as you can see from the 1-year stock market returns above vs. the starting CAPE ratio.
It does do a pretty good job over the medium term, as valuations tend to mean revert over time. See the 5-year return of the market vs. the beginning CAPE ratio below.
Like a good superhero, it may be well worth your time to make sure your CAPE fits before leaving the house.
-Paul R. Rossi, CFA