Is the stock market expensive? It is one of the most common questions in investing, and one of the hardest to answer. The Shiller CAPE ratio is a popular attempt. It compares share prices with average earnings over the previous ten years, adjusted for inflation, to give a long-term view of value. It is useful, widely quoted and often misunderstood.
What CAPE stands for
CAPE means cyclically adjusted price-to-earnings ratio. It was developed by the economist Robert Shiller, building on earlier work by Benjamin Graham and David Dodd. A normal price-to-earnings ratio divides a share price or index level by one year’s earnings. CAPE instead divides by the average of the last ten years of earnings, with each year adjusted for inflation.
Why use ten years?
Company profits swing with the economy. In a boom, earnings are high and a normal price-to-earnings ratio can make shares look cheap. In a recession, earnings collapse and the same ratio can make shares look absurdly expensive. Averaging over ten years smooths out a full business cycle, so the ratio reflects something closer to normal earnings power.
How to read it
A high CAPE suggests investors are paying a lot for each pound or dollar of long-run earnings. A low CAPE suggests shares are relatively cheap. Historically, periods of very high CAPE readings for US shares, such as the late 1990s, were followed by weak returns over the next decade. Periods of low readings, such as the early 1980s, were followed by strong ones.
This is the key point: CAPE has a reasonable record of hinting at long-term returns over ten years or more. It has a very poor record of predicting what happens next month or even next year. Markets can stay expensive for a long time.
CAPE versus the forward P/E
Analysts often quote a forward price-to-earnings ratio, which uses expected earnings for the next twelve months. That ratio responds quickly to changes in profit forecasts. CAPE moves slowly because it looks back a decade. The two can tell different stories: forward valuations can look reasonable while CAPE stays high, because recent earnings growth has been strong. Our guide to the forward P/E ratio explains the other side.
The criticisms
Critics point out that accounting rules have changed over time, that today’s markets contain more high-margin technology companies than in the past, and that lower interest rates in recent decades may justify higher valuations. Each of these arguments suggests the long-run average may not be the right benchmark for today.
How traders use it
Most traders treat CAPE as a measure of the background risk rather than a timing tool. A high reading might encourage more caution, more diversification or more attention to risk management. It would rarely be the reason to buy or sell on its own. Our latest Morning Market Brief shows the shorter-term forces moving markets day to day.
The beginner takeaway
CAPE tells you about the long road, not tomorrow’s weather. Use it to set expectations, not to time your entries.
If you want to understand how your own approach balances long-term thinking with short-term trading, the Samuel & Co Trading Trader Assessment is a good next step.
