Shiller’s CAPE, or Cyclically Adjusted Price to Earnings, ratio has long been used as a guide for future expected returns on the market. The CAPE ratio is calculated by taking the price of a security divided by an average 10 years of earnings adjusted for inflation. A 10-year average of EPS (earnings per share) is used to help smooth out the effects from the business cycle and show the sustainable earnings power of a company.
Similar to other metrics used to forecast returns, the lower the ratio, the higher the expected return. For example, if we have a CAPE of 15, it would imply future returns of 6.7%, while a CAPE of 30 would imply future returns of 3.33%.
There can be some distortions to the numbers given the 10-year time span that our EPS average covers. We are in the midst of one of those given that within our 10-year span of average earnings we encompass the 2008/2009 Great Recession. As we start to drop 2008 and 2009 out of the average this could have a positive effect on the denominator in the equation thus reducing our CAPE ratio and raising expected future returns.
There are many moving parts and variables that are likely to change within the equation. This is not a market timing tool, but rather a tool that can be used to set expectation for potential future returns.
