The Cyclically Adjusted Price-to-Earnings ratio — an equity market valuation measure using 10-year average inflation-adjusted earnings — which has historically predicted long-term equity returns with high reliability.
“Valuations don't tell you when, but they tell you with high reliability what the next ten years will bring.”
— Jeremy Grantham
Deeper Explanation
The CAPE ratio (also known as the Shiller P/E, after its creator Robert Shiller) smooths the volatility of single-year earnings by using the average inflation-adjusted earnings of the past 10 years. This addresses the well-documented problem with single-year P/E ratios: they appear lowest at cyclical earnings peaks (when investors should be cautious) and highest at cyclical earnings troughs (when investors should be buying), giving systematically misleading signals about relative value. The 10-year average smooths through the business cycle, providing a more stable estimate of normalised earning power that correlates more reliably with long-run equity returns. Research by Shiller and others has consistently shown that starting CAPE levels explain a significant fraction of the variance in subsequent 10-year equity returns: high starting CAPE (above 25–30) has historically preceded below-average 10-year returns; low starting CAPE (below 10–15) has historically preceded above-average 10-year returns. Jeremy Grantham has used the CAPE ratio extensively as a bubble-detection tool, noting that every equity market valuation above two standard deviations from its long-run mean (using CAPE or other metrics) has historically reverted. By this standard, the US equity market has been statistically overvalued for extended periods in the late 1990s, the 2010s, and the early 2020s — periods that have indeed been followed by significant corrections, though often with long lags. The CAPE ratio's limitations are important to understand. It is a long-term valuation tool, not a short-term timing tool: elevated CAPE ratios can persist for years or even a decade before the reversion occurs. It is also relative to the interest rate environment: when interest rates are very low, higher than historical CAPE ratios may be justified (since future cash flows discount at a lower rate). Finally, accounting changes over the decades have altered what earnings represent, potentially inflating CAPE ratios relative to historical comparisons.
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