The Shiller CAPE Ratio: A New Look

Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overpessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly.The summary was prepared by Mark K. Bhasin, CFA, Basis Investment Group LLC.How Did the Author Conduct This Research?The author performs regressions on the CAPE ratio using three measures of earnings. He plots the CAPE ratio from 1881 through 2014, which shows that the model explains about one-third of the movement in future 10-year real stock returns. He also plots after-tax per share earnings for S&P reported earnings, S&P operating earnings, and NIPA real after-tax corporate profits as published in the NIPAs. The latter plot shows that sharp declines of S&P reported earnings have increased significantly since 1991.To show that the volatility of S&P reported earnings has increased significantly in the last three business cycles, the author reports earnings declines in recessions from 1929 to 2014. In the last three recessions (1990, 2001, and 2008–2009), S&P reported earnings decreased by more than twice as much as NIPA corporate profits. The author points out that the change in the computation of S&P reported earnings has resulted in a shift from understating earnings declines during economic downturns to significantly overstating them.The author concludes that using NIPA corporate profits instead of the S&P reported earnings produces higher projected stock market returns.Abstractor’s ViewpointThe CAPE ratio is used by finance practitioners in an attempt to gauge the S&P 500’s level of valuation. The author convincingly argues that changes in US accounting standards have led to an overstatement of earnings declines in recessions and an artificially high CAPE ratio. Given the current popularity of the CAPE ratio by finance practitioners and the media, the author’s research demonstrates that further analysis is required to successfully use this ratio for investment purposes.Editor’s note: The article was reviewed and accepted by Executive Editor Robert Litterman.