Economic p e ratio

What Is the Economic P/E Ratio?

The Economic P/E Ratio, more formally known as the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio or Shiller P/E Ratio, is a valuation measure used in investment valuation to assess whether a broad market index, such as the S&P 500, is undervalued or overvalued. It stands apart from conventional price-to-earnings ratios by smoothing out fluctuations in corporate earnings over an extended period, typically ten years. This adjustment helps to mitigate the impact of short-term volatility and economic cycles, offering a more stable and comprehensive view of market valuation. By providing a clearer signal of long-term market trends, the Economic P/E Ratio assists investors in understanding potential future equity returns by relating current prices to normalized earnings.

History and Origin

The concept behind the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio was popularized by Nobel laureate economist Robert J. Shiller and his colleague John Campbell. Shiller began developing this ratio in the late 1980s, driven by the belief that traditional one-year price-to-earnings ratios were too volatile to provide reliable insights into long-term market prospects. He sought a metric that could account for the cyclical nature of business cycles and earnings.

The ratio gained significant prominence during the dot-com bubble of the late 1990s, when Shiller notably argued that equity markets were highly overvalued based on the CAPE ratio's readings. His work, including data made publicly available, has provided historical context stretching back over a century for market analysis. The methodology of averaging ten years of earnings per share, adjusted for inflation, aims to offer a more robust indicator of market valuation by smoothing out temporary economic booms and busts, providing a broader, more stable economic perspective for long-term investors.

Key Takeaways

• The Economic P/E Ratio (CAPE) normalizes earnings over a 10-year period, adjusted for inflation, to provide a smoothed market valuation.
• It is used to assess whether broad stock market indices are overvalued or undervalued, indicating potential long-term returns.
• Developed by Robert J. Shiller, it helps mitigate the impact of short-term economic fluctuations on valuation metrics.
• Historically, higher CAPE ratios have been associated with lower long-term future returns, and vice versa.
• The Economic P/E Ratio serves as a tool for long-term strategic asset allocation rather than short-term trading decisions.

Formula and Calculation

The Economic P/E Ratio (CAPE) is calculated by dividing the current real price of a stock index by the average of the previous ten years' real (inflation-adjusted) earnings per share.

The formula is as follows:

$\text{Economic P/E Ratio (CAPE)} = \frac{\text{Current Real Stock Index Price}}{\text{Average of Last 10 Years' Real Earnings Per Share}}$

Where:

• Current Real Stock Index Price: The current price of the chosen stock market index, adjusted for inflation (e.g., using the Consumer Price Index).
• Average of Last 10 Years' Real Earnings Per Share: The arithmetic average of the index's earnings per share over the past ten years, with each year's earnings figure also adjusted for inflation to present-day values.

This approach provides a more stable earnings base compared to using just a single year's earnings, which can be distorted by economic peaks or troughs within business cycles.

Interpreting the Economic P/E Ratio

Interpreting the Economic P/E Ratio involves comparing its current value to its historical average. A high Economic P/E Ratio, relative to its long-term average, suggests that the market may be overvalued, implying lower expected long-term returns on equity. Conversely, a low Economic P/E Ratio can indicate that the market is undervalued, potentially signaling higher future returns.

For instance, if the historical average CAPE ratio for a market is around 16x and the current ratio is 30x, it suggests that investors are paying significantly more for each dollar of normalized earnings than they have historically. This can be a signal for investors to moderate their expectations for future market performance or to consider a more conservative investment strategy.

It is important to consider the ratio in conjunction with other economic indicators and financial models rather than in isolation, as various factors can influence its interpretation. The ratio helps gauge overall market sentiment and can provide a macro perspective on market health.

Hypothetical Example

Consider a hypothetical market index, "Diversification 100," for which we want to calculate the Economic P/E Ratio.

First, we gather the inflation-adjusted earnings per share (EPS) for the past 10 years for the Diversification 100 index:

• Year 1: $50
• Year 2: $55
• Year 3: $48
• Year 4: $60
• Year 5: $62
• Year 6: $58
• Year 7: $65
• Year 8: $53
• Year 9: $70
• Year 10: $72

Next, we calculate the average of these 10 years' real EPS:

$\text{Average Real EPS} = \frac{(50+55+48+60+62+58+65+53+70+72)}{10} = \frac{593}{10} = \$59.30$

Now, assume the current real price of the Diversification 100 index is $2,000.

Using the Economic P/E Ratio formula:

$\text{Economic P/E Ratio} = \frac{\text{Current Real Stock Index Price}}{\text{Average of Last 10 Years' Real Earnings Per Share}}$
$\text{Economic P/E Ratio} = \frac{\$2,000}{\$59.30} \approx 33.73$

In this hypothetical example, the Diversification 100 index has an Economic P/E Ratio of approximately 33.73. This figure would then be compared to the historical average CAPE of the Diversification 100, or a similar broad market index, to determine if the market is currently overvalued or undervalued relative to its long-term earnings potential. This helps investors make informed decisions about their portfolio construction.

Practical Applications

The Economic P/E Ratio is primarily used by long-term investors and macro-analysts for strategic insights into broad market valuation. One key application is in asset allocation decisions, guiding investors on how much capital to commit to equity markets versus other asset classes, such as bonds or real estate. A high Economic P/E Ratio might signal a period where expected future stock returns are lower, leading investors to consider reducing their equity exposure or diversifying into other investment vehicles.

Furthermore, economists and policymakers may reference broad price-to-earnings ratios, including the CAPE, when assessing potential financial system vulnerabilities and overall market stability. For instance, the Federal Reserve's financial stability reports sometimes highlight equity price-to-earnings ratios as an indicator of asset valuations within the financial system, noting when they move towards the upper end of historical distributions⁴. This ratio also finds application in academic research on market efficiency and forecasting long-term market trends. Financial analysts use it to gain a smoothed perspective on market trends that isn't distorted by short-term economic fluctuations or anomalous earnings per share figures. For example, Lyn Alden's analysis highlights its utility in assessing whether a market is overvalued, undervalued, or fairly valued³.

Limitations and Criticisms

While the Economic P/E Ratio offers a valuable long-term perspective on market valuation, it also faces several limitations and criticisms. One common critique is that its historical averages may not be directly comparable to current market conditions due to significant shifts in accounting standards, corporate profitability, and the composition of market indices over time². Changes in Generally Accepted Accounting Principles (GAAP), for instance, can impact reported earnings per share, potentially skewing the ratio's historical consistency.

Another limitation is its lack of predictive power for short-term market movements. The Economic P/E Ratio is a long-term indicator and does not signal imminent market crashes or rallies; its primary utility lies in forecasting returns over decades rather than months or a few years. Furthermore, critics argue that the ratio doesn't adequately account for factors such as prevailing interest rates, which can influence fair valuation levels. Low interest rates, for example, might justify higher P/E ratios as investors accept lower earnings yields in a low-return environment. The measure also assumes a relatively static mix of stocks over time, which may not hold true in today's dynamic markets dominated by high-growth technology companies¹. Therefore, while informative for strategic decisions like portfolio construction, it should be used in conjunction with other economic indicators and financial ratios for a comprehensive analysis.

Economic P/E Ratio vs. Trailing P/E Ratio

The Economic P/E Ratio (CAPE) and the Trailing P/E Ratio are both valuation metrics, but they differ significantly in their calculation and application, often leading to confusion.

The core distinction lies in the earnings component. The Economic P/E Ratio aims to normalize earnings over a full economic cycle, thereby providing a more stable and less volatile measure of market valuation. This makes it particularly useful for assessing broad market levels and informing long-term equity investment decisions. In contrast, the Trailing P/E Ratio reflects a company's or index's current price relative to its most recent 12 months of earnings. While simpler and widely used for individual stock analysis and peer comparisons, it can be significantly distorted by cyclical highs or lows in profitability. Investors use the Trailing P/E Ratio for a more immediate look at how much they are paying for a company's past year of profits.

FAQs

What does a high Economic P/E Ratio indicate?

A high Economic P/E Ratio generally indicates that the overall stock market is overvalued relative to its long-term historical earnings. This often suggests that future long-term returns from equity investments may be lower than historical averages.

How is the Economic P/E Ratio different from a standard P/E ratio?

The key difference is the earnings component. A standard P/E ratio (like the Trailing P/E Ratio) uses a company's or index's earnings per share from the past 12 months. The Economic P/E Ratio, however, uses the average of the past ten years' inflation-adjusted earnings, smoothing out the impact of business cycles and providing a more normalized view of valuation.

Can the Economic P/E Ratio predict market crashes?

While a very high Economic P/E Ratio has historically preceded significant market downturns (such as those before 1929, 2000, and 2008), it is not a precise timing tool for market crashes. It is a long-term economic indicator of potential overvaluation and implies lower expected returns over extended periods, rather than forecasting immediate events.

Is the Economic P/E Ratio used for individual stock analysis?

No, the Economic P/E Ratio is typically applied to broad market indices, like the S&P 500, rather than individual stocks. It provides insights into the overall market's valuation and potential long-term returns, making it unsuitable for analyzing specific company performance or for use in discounted cash flow models for single securities.

What are the limitations of relying solely on the Economic P/E Ratio?

Sole reliance on the Economic P/E Ratio can be misleading because it does not account for changes in accounting standards, prevailing interest rates, or the evolving composition of market indices. It is a macro-level tool and does not offer insights into company-specific factors or short-term market sentiment shifts. Therefore, it should be used in conjunction with other financial ratios and analytical tools.