Adjusted aggregate p e ratio

What Is Adjusted Aggregate P/E Ratio?

The Adjusted Aggregate P/E Ratio is a market valuation metric used to assess the overall valuation of a broad stock market or index, often taking into account cyclical variations in corporate earnings or other economic factors. Unlike a simple Price-to-Earnings Ratio (P/E) which uses a single period's earnings, an adjusted aggregate P/E ratio aims to provide a more stable and less volatile measure of valuation over longer periods by smoothing out temporary fluctuations in corporate profits that occur over an economic cycle. This adjustment helps investors gain a clearer perspective on whether the market is overvalued or undervalued, influencing their investment strategy and asset allocation decisions.

History and Origin

The concept of adjusting aggregate P/E ratios to account for cyclical fluctuations in earnings gained prominence with the work of economists like Benjamin Graham and David Dodd, who, in their seminal work "Security Analysis," advocated for averaging a firm's earnings over several years to get a more accurate picture of its true earning power. They recognized that single-year earnings could be too volatile.

However, the most widely recognized form of an Adjusted Aggregate P/E Ratio, the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, was popularized by Nobel laureate economist Robert J. Shiller. Shiller developed this metric to smooth out the impact of business cycles and inflation on reported earnings. He detailed the ratio in his book, "Irrational Exuberance," and made extensive historical data available.¹⁴,,¹³ Shiller's aim was to provide a more robust valuation tool that could indicate potential long-term returns, rather than being swayed by short-term market euphoria or distress.¹²

Key Takeaways

• The Adjusted Aggregate P/E Ratio provides a smoothed, long-term perspective on market valuation by averaging earnings over multiple years, typically a decade.
• It helps to filter out the noise of short-term earnings volatility caused by economic cycles and one-off events, offering a more stable measure for assessing market sentiment.
• A higher Adjusted Aggregate P/E Ratio may suggest that the market is overvalued, implying lower potential long-term returns, while a lower ratio could indicate undervaluation and higher potential returns.
• This metric is a valuable tool for strategic asset allocation and identifying periods of potential market exuberance or pessimism.
• While widely used, it has limitations, including its backward-looking nature and potential for structural shifts in the economy to render historical averages less relevant.

Formula and Calculation

The most common form of the Adjusted Aggregate P/E Ratio is the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, also known as the Shiller P/E or P/E 10. Its formula is:

Where:

• Current Market Price Index: The current value of a broad market index, such as the S&P 500.
• Average of Last 10 Years' Inflation-Adjusted Earnings: This is the arithmetic mean of the real (inflation-adjusted) earnings per share (EPS) for the constituent companies of the index over the preceding ten years. The use of real earnings adjusts for the purchasing power of money over time due to inflation.

To calculate the inflation-adjusted earnings, historical nominal earnings are typically divided by the Consumer Price Index (CPI) from their respective periods and then multiplied by the current CPI, effectively bringing all past earnings to present-day purchasing power. The Bureau of Economic Analysis (BEA) provides relevant data for calculating corporate profits.¹¹

Interpreting the Adjusted Aggregate P/E Ratio

Interpreting the Adjusted Aggregate P/E Ratio involves comparing its current value to its historical average. A high Adjusted Aggregate P/E Ratio, significantly above its historical mean, suggests that the market may be overvalued relative to historical norms. Conversely, a low Adjusted Aggregate P/E Ratio might indicate an undervalued market.

For example, the average CAPE ratio for the S&P 500 throughout the 20th century was approximately 15.21. When the ratio climbs significantly higher than this, it often signals periods of elevated investor optimism or "irrational exuberance." During such times, the market may be pricing in exceptionally high future growth that might not materialize, increasing the risk of lower returns over the subsequent 10 to 20 years.¹⁰,

Conversely, a ratio substantially below the historical average could signal that investor sentiment is overly pessimistic, potentially presenting opportunities for investors seeking higher long-term returns. It’s important to consider this metric in conjunction with other valuation multiples and economic indicators, as various factors, such as prevailing interest rates and productivity growth, can influence its equilibrium level over time.

⁹## Hypothetical Example

Suppose an investor, Sarah, is evaluating the overall financial health of the U.S. stock market using an Adjusted Aggregate P/E Ratio. She gathers the following hypothetical data:

• Current S&P 500 Index Price: 5,200
• Average of last 10 years' inflation-adjusted earnings for the S&P 500 companies: $180

Using the formula for the Adjusted Aggregate P/E Ratio (CAPE):

Now, Sarah compares this value to the historical average CAPE ratio, which she knows is around 16 for the S&P 500. Her calculated Adjusted Aggregate P/E Ratio of 28.89 is significantly higher than the historical average. This suggests to Sarah that, based on this metric, the overall market is currently trading at a premium and may be overvalued. This insight could influence her decision to potentially reduce her exposure to broad market equities or consider other asset classes.

Practical Applications

The Adjusted Aggregate P/E Ratio finds several practical applications in investment analysis and financial planning:

• Long-Term Market Forecasting: Investors and financial analysts use the Adjusted Aggregate P/E Ratio to forecast long-term stock market returns. Historically, periods of high CAPE ratios have been followed by lower average real returns over the subsequent 10 to 20 years, while low CAPE ratios have preceded higher returns. This makes it a strategic tool for setting realistic expectations.
• Strategic Asset Allocation: For institutional investors and sophisticated individual investors, the Adjusted Aggregate P/E Ratio can inform strategic asset allocation decisions. If the ratio indicates an overvalued market, an investor might consider rebalancing their portfolio away from equities and towards less volatile assets like bonds, or exploring international markets with lower valuations.
• Behavioral Finance Insights: The ratio often reflects prevailing market sentiment, sometimes indicating periods of "irrational exuberance" or undue pessimism. High readings can correspond to speculative bubbles, while low readings might occur during market panics or a recession.
• Monetary Policy Analysis: Central banks, such as the Federal Reserve, monitor broad asset valuations as part of their financial stability assessments. Elevated valuations, potentially highlighted by a high Adjusted Aggregate P/E Ratio, in an environment of low interest rates, can signal increased risks to financial stability. F⁸ederal Reserve officials frequently discuss market valuations in their speeches, acknowledging their significance to economic outlook.,,⁷,^{6
  5
  4}## Limitations and Criticisms

Despite its utility, the Adjusted Aggregate P/E Ratio faces several limitations and criticisms:

• Backward-Looking Nature: The ratio relies on historical earnings data, typically over the past ten years. Critics argue that past performance is not indicative of future results, and structural changes in the economy, such as shifts in industry composition, accounting standards, or global competitive landscapes, can make historical averages less relevant for current valuation.
• Changes in Interest Rate Environment: Some argue that the "normal" level of the Adjusted Aggregate P/E Ratio may have fundamentally shifted due to persistently low real interest rates over recent decades. L³ower discount rates, influenced by central bank monetary policy, can theoretically justify higher equity valuations. This perspective is often discussed in relation to the "Fed Model," which suggests a relationship between earnings yields and bond yields.
  *² Exclusion of Intangible Assets: The earnings used in the calculation primarily reflect tangible assets and reported profits. In modern economies, a significant portion of corporate value comes from intangible assets like intellectual property, brand recognition, and network effects, which may not be fully captured in traditional earnings figures, potentially skewing the ratio's interpretation.
• Lack of Timing Signal: While the Adjusted Aggregate P/E Ratio may indicate long-term return potential, it is not a precise market-timing tool. High readings can persist for extended periods before a significant market correction, and low readings might not immediately lead to a rally.

¹## Adjusted Aggregate P/E Ratio vs. Cyclically Adjusted Price-to-Earnings (CAPE) Ratio

The relationship between the Adjusted Aggregate P/E Ratio and the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio is one of nomenclature rather than fundamental difference. In practice, the CAPE Ratio, often referred to as the "Shiller P/E" or "P/E 10," is the most prominent and widely used form of an adjusted aggregate P/E ratio.

The term "Adjusted Aggregate P/E Ratio" serves as a broader category that encompasses any P/E ratio applied to an entire market or index that incorporates adjustments (such as smoothing earnings, adjusting for inflation, or considering other economic factors) to provide a more stable valuation metric. The CAPE Ratio is a specific methodology within this broader category, distinguished by its use of a 10-year average of inflation-adjusted earnings. Therefore, when financial professionals refer to an "Adjusted Aggregate P/E Ratio," they are most often referring to the CAPE Ratio due to its established methodology and extensive historical data. Both aim to mitigate the volatility inherent in single-period earnings and provide a more robust indicator of market valuation over the long term.

FAQs

What does "aggregate" mean in this context?

"Aggregate" refers to the entire market or a broad market index, such as the S&P 500, rather than a single company's stock. It represents the combined value of all the companies within that index. The market capitalization of all constituent companies forms the numerator, and their collective earnings form the denominator.

Why is a 10-year average used for earnings?

A 10-year average for earnings is used to smooth out the effects of business cycles and temporary economic booms or recessions. This longer period helps to normalize profits, giving a clearer picture of a company's or market's underlying earning power over time, rather than being skewed by unusually high or low earnings in a single year.

How does inflation adjustment work for earnings?

Inflation adjustment means that historical earnings figures are converted into current dollar terms. This accounts for the decrease in purchasing power over time due to inflation, ensuring that all earnings figures used in the average calculation are comparable in real terms. This process provides a truer measure of historical corporate profits.

Can the Adjusted Aggregate P/E Ratio predict market crashes?

No, the Adjusted Aggregate P/E Ratio is not a precise market-timing indicator or a predictor of specific market crashes. While historically, very high readings have sometimes preceded periods of poor long-term returns or significant market corrections, there is no guarantee that a high ratio will immediately lead to a downturn. It's best used as a long-term valuation signal rather than a short-term trading signal.

Is this ratio useful for individual stock picking?

While the Adjusted Aggregate P/E Ratio provides insights into the overall market's valuation, it is not typically used for selecting individual stocks. For single companies, investors usually rely on traditional P/E ratios, enterprise value multiples, and other specific valuation metrics tailored to individual company analysis and their unique growth prospects and industry dynamics.