What is the CAPE ratio?

The CAPE ratio (Cyclically Adjusted Price-to-Earnings), also known as the Shiller P/E after Nobel laureate Robert Shiller who popularized it, divides the current S&P 500 price level by the average of real (inflation-adjusted) earnings over the preceding 10 years. By using a decade of earnings, the CAPE smooths out the business cycle's effect on profits, preventing the ratio from appearing artificially cheap during earnings booms or artificially expensive during earnings recessions.

The historical average CAPE for the S&P 500 is approximately 17. The ratio fell below 10 at major market bottoms (1920, 1932, 1982) and exceeded 40 at the dot-com peak (December 1999). Readings persistently above 25 have historically been associated with below-average forward 10-year returns, while readings below 15 have been associated with above-average forward returns. The relationship is strongest over 10-year horizons and weakest for short-term predictions.

As of recent readings, the CAPE has been trading in the 33-38 range, well above historical averages and in the top decile of historical observations. Critics of the CAPE argue that several structural changes justify a permanently higher level: changes in accounting standards (particularly the treatment of intangible investment), the higher profitability of technology-heavy index composition, lower interest rates during much of the CAPE's lookback window, and share buybacks that have concentrated earnings into fewer shares.

For long-term investors and asset allocators, the CAPE provides a useful framework for calibrating return expectations. When the CAPE is elevated, expected 10-year real returns for equities tend to be lower (currently implying roughly 2-4% real annually), while bonds and alternatives become relatively more attractive. The CAPE does not time the market; it was elevated throughout the 2010s bull market and stocks continued to rise. Instead, it sets realistic expectations for the range of likely long-term outcomes and helps investors determine whether the current risk-reward favors equities or competing asset classes.