Reassessing Market Valuation: A New Perspective on the CAPE Ratio

The cyclically adjusted price/earnings ratio, commonly referred to as the CAPE ratio, has been a pivotal tool used by investors and analysts to determine the valuation of the stock market. This metric compares the current level of the S&P 500 index to its underlying earnings trend, aiming to assess whether the market is overvalued or undervalued. According to the traditional interpretation of the CAPE ratio, the S&P 500 is currently priced higher than it has been since 1871, aside from the peak of the dot-com bubble. However, a recent study suggests that this assessment may not accurately reflect the true state of market valuation.

A Shift in Understanding

The study, titled “Current Constituents CAPE,” was conducted by researchers Trent Commins, Ted Hsu, and Seanna Kim from Research Affiliates, an investment advisory firm known for its innovative approaches. They argue that the traditional CAPE ratio, made famous by Yale professor and Nobel laureate Robert Shiller, may be flawed due to its methodology. Specifically, the conventional calculation averages out earnings per share over the trailing 10 years while adjusting for inflation. This long-term view aims to mitigate the effects of economic volatility and provide insight into corporate America’s potential. However, the researchers highlight a critical issue: when a company is removed from the index — usually due to poor performance — its earnings continue to influence the CAPE calculation for years. This creates a bias that can misrepresent the market’s true valuation.

The Proposal of CC-CAPE

To address these shortcomings, the researchers proposed an alternative called the Current Constituents CAPE (CC-CAPE). Instead of relying on historical earnings from companies that have been removed from the index, the CC-CAPE focuses solely on the earnings of the current constituents of the S&P 500. By calculating a CAPE ratio for each company in the index and averaging those values based on their market weight, this measure aims to provide a more accurate reflection of current market conditions.

The researchers’ motivation stemmed from their observation that companies deleted from the S&P 500 tend to have lower performance and depressed earnings, while the new additions usually have stronger earnings potential. This discrepancy has led to significant biases in the traditional CAPE ratio, and the new methodology has shown promise in addressing those inaccuracies.

Predictive Power of CC-CAPE

Through extensive testing over the past 60 years, Commins, Hsu, and Kim demonstrated that the CC-CAPE has more accurately predicted subsequent stock market returns over various time horizons (one, three, five, and ten years) compared to the traditional CAPE ratio. This new indicator has emerged as a more reliable tool for assessing market conditions and making informed investment decisions.

The CAPE Spread: A Measure of Market Sentiment

The researchers further introduced the concept of the CAPE Spread, which highlights the differences between the traditional CAPE and the CC-CAPE. They argue that this spread serves as an indicator of market sentiment, particularly during periods of frequent composition changes in the S&P 500. Historical data suggests that a widening CAPE Spread correlates with elevated levels of irrational market behavior, with the current spread remaining slightly above average but significantly below the highs seen during the dot-com bubble.

Composite Indicator: A Holistic Approach

In their pursuit of a comprehensive market assessment, the researchers developed a composite indicator that merges elements of the traditional CAPE and the CAPE Spread. This composite indicator offers a balanced view by integrating fundamental valuation metrics and market sentiment, resulting in even greater predictive accuracy than either CAPE measure alone. In fact, its forecasting ability surpassed the traditional CAPE by more than double across one-, three-, and five-year horizons.

Implications for Investors

The insights drawn from the CC-CAPE and its associated measures present a nuanced perspective for today’s investors. While the traditional CAPE suggests a problematic level of market overvaluation, the reduced levels of irrational exuberance indicated by the CAPE Spread may suggest a more tempered market sentiment. As such, rather than a clear “red light for equity risk-taking,” the combined findings point to a “flashing yellow,” signaling caution but also opportunity in the current market landscape.

In conclusion, the emergence of advanced analytical tools, such as the CC-CAPE and its composite indicator, poses an important question for investors: How should we weigh fundamental valuations against market sentiment in an ever-evolving economic environment? The evolving discourse surrounding market indicators will likely shape investment strategies moving forward, urging market participants to look beyond traditional measures and consider new methodologies that resonate with today’s financial reality.