Cyclically Adjusted Price-Earnings Ratio
Smooth earnings across a cycle to set realistic long-term return expectations
- Difficulty
- Easy
- Time to result
- ~days to results
- Steps
- 6
- Confidence
- 99%
The cyclically adjusted price-earnings ratio replaces the conventional one-year earnings denominator with average earnings over ten years, normally adjusted for inflation. This smooths recessions, temporary profit spikes, and other year-to-year volatility that can make an ordinary P/E misleading. Apply it primarily to broad indexes or sectors, then compare the current ratio with its own historical range. Higher CAPE readings have generally corresponded to lower subsequent long-term real returns, while lower readings have corresponded to better returns. CAPE is therefore an expectations tool rather than a precise timing signal. Portfolio decisions should still account for bond valuations, diversification, investment horizon, and personal risk capacity.
Origin
Robert Shiller developed the measure with his former student John Campbell in the 1980s, building on the longstanding practice of judging investments through price-earnings ratios.
Core principles
- 01Valuation matters over long horizons
- 02One year of earnings is too volatile to anchor value
- 03A decade of earnings better represents a business cycle
- 04High valuation implies lower expected returns, not an imminent crash
How to run it
- 1
Choose a diversified market
Select a broad equity index or sector with a sufficiently long and consistent earnings history. Confirm that constituent and accounting data are reasonably comparable over time.
Pro tip Start with indexes before attempting narrower applications.
Watch out Shiller cautions that many individual companies lack a meaningful ten-year earnings record.
- 2
Normalize the data
Gather the current index price and ten years of earnings, then adjust the historical figures for inflation. This places prices and earnings in comparable real terms.
Pro tip Use one consistent inflation series throughout the calculation.
Watch out Mixing nominal and real figures invalidates the ratio.
- 3
Smooth ten years of earnings
Calculate the average of the ten annual real earnings observations. The resulting denominator dampens temporary booms, recessions, and accounting volatility.
Pro tip Document exceptional earnings events, but do not remove them without a consistent rule.
Watch out Shortening the window reintroduces cyclical noise.
- 4
Calculate and contextualize CAPE
Divide the current real price by average real earnings and compare the result with the market’s historical CAPE distribution. Classify the reading as inexpensive, typical, elevated, or extreme.
Pro tip Compare like markets and consistent historical series.
Watch out A structurally different market may not share another market’s normal valuation range.
- 5
Set return expectations
Use historical outcomes associated with similar CAPE levels to estimate a range of long-term real returns. Treat the range as probabilistic rather than guaranteed.
Pro tip Present scenarios instead of a single-point forecast.
Watch out CAPE can remain elevated for years and should not trigger automatic short-term trades.
- 6
Personalize the portfolio response
Balance expected equity returns against alternative assets and the investor’s horizon, income needs, and tolerance for loss. Rebalance according to a defined policy rather than emotion.
Pro tip Use CAPE to calibrate expectations, not to eliminate diversification.
Watch out There is no universal allocation suitable for every investor.
In the wild
The S&P 500 CAPE reached the forties around the technology-market peak. The index then took roughly thirteen years to move sustainably beyond its prior nominal high, illustrating how extreme starting valuations can suppress long-horizon returns even when prices experience large interim rallies.
→ The elevated CAPE correctly warned investors to expect weak long-term returns, though it did not specify the exact path.
When CAPE is above its historical norm but far below prior bubble records, an investor can lower expected ten-year returns without abandoning equities. If bonds are also expensive, a diversified and regularly rebalanced allocation may remain reasonable for someone with sufficient time and risk capacity.
→ Valuation informs realistic expectations while preserving diversification.
Common mistakes
Treating CAPE as a crash clock
An elevated ratio predicts lower average long-term returns more reliably than it predicts an immediate reversal.
Applying it blindly to single stocks
Corporate lifecycles and limited earnings histories can make a ten-year average irrelevant for individual companies.
Ignoring personal circumstances
The same valuation reading can justify different allocations for a young saver and a retiree dependent on portfolio income.
Is it for you?
Best for
It is best for investors setting ten-year expectations or comparing valuations across broad markets and sectors.
Not ideal for
It is not ideal for short-term market timing or young individual companies without a stable ten-year earnings history.
From the transcript
“we thought, let's just average the earnings over more years, so you're taking ten years instead of a single quarter or a single year.”
“when the CAPE ratio is high, you get worse returns.”
“if the price is high relative to what it's been doing for the last ten years, and maybe it's not such a great time to…”
From the episode
Masters in Business: Yale Professor Robert Shiller (Audio)
Robert Shiller