Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 239

The CAPE hanging over share markets

The long-anticipated fall in US share markets and return of volatility finally arrived this week, with the S&P 500 down 4.1% on Monday 5 February 2018 after a 2% fall the previous Friday. Following this lead, the S&P/ASX200 fell 2% then 3.5%, and the headlines screamed of panic selling and a wipe out of billions of dollars of wealth.

But these movements always require a context. The S&P 500 was up 5.6% in January 2018 alone, hitting all-time highs. Long-term investment plans should expect stock markets to move like this regularly.

What matters more is where the market is headed for the long term, and whether it offers value compared with historical levels.

Two weeks ago, Robert Shiller, 2013 Nobel laureate in Economic Sciences, and co-inventor of the CAPE measure, was calling the US the “world’s priciest stock market” because the CAPE ratio was higher than every other country measured.

Development of the CAPE ratio

Thirty years ago, in February 1988, Robert Shiller and John Campbell presented a paper to NBER (National Bureau of Economic Research) that led to the cyclically-adjusted price-to-earnings (CAPE) ratio. The CAPE ratio is the real (inflation-adjusted) price of a share divided by a ten-year average of real earnings per share. It's an alternative to the more common P/E ratio.

Why ten years? Says Shiller:

“Ownership of stock represents a long-term claim on a company’s earnings, which the company can pay to the owners of shares as dividends or reinvest to provide the shareholders more dividends in the future. A share in a company is not just a claim on next year’s earnings, or on earnings the year after that. Successful companies last for decades, even centuries.”

Earnings can be volatile from year to year, but research indicates there is mean reversion in earnings, which means there’s value in using long-term averages.

The CAPE ratio reached an all-time high during the dot-com bubble. It also reached a historically high level again during the GFC up to 2007. Today, Barclays Bank in London compiles the CAPE ratios for 26 countries using Robert Shiller as a consultant.

As shown below, the historical mean of the CAPE for US markets is 16.8. At the close of 5 February, it stood at 32, or 90% higher (the regular P/E ratio has an historical mean of 16 and stood at 25).

Shiller and Campbell found that the lower the CAPE, the higher the investors' likely return from equities over the following 20 years. A comparison of CAPE values might assist in identifying the best markets for future equity returns.

Is the US market overpriced?

Two weeks ago, writing in Project Syndicate, Shiller expressed a concern that the CAPE ratio is at an historical high in the US and that it is higher than for any other country that it is measured for. At the end of 2017, the CAPE ratios for five major economies were: US 30.9, Australia 21.4, China 24.6, Japan 29.2, and UK 18.6.

While this might indicate some cause for concern, especially in the US, a high CAPE ratio need not mean that the market is necessarily overpriced.

Contrarian Geoffrey Caveney finds a reason for why the US CAPE ratio is now around its historic highs (it was only higher in the late 90s dot-com bubble):

“However, this is misleading right now because the CAPE ratio's 10-year back period begins with the Great Recession in 2007. So the 10-year earnings are abnormally low, due to the effect of 2007-2009 on the 10-year average. As the recession years ‘roll off’ the 10-year back period, the 10-year average earnings will increase, and stock prices can rise without making the Shiller CAPE ratio rise excessively.”

Diversify rather than justify

Even when using his own measure, Shiller cautions against being too sure of the reason it is high:

“… the mystery of what’s driving the US stock market higher than all others, [is] not the “Trump effect,” or the effect of the recent cut in the US corporate tax rate. After all, the US has pretty much had the world’s highest CAPE ratio ever since President Barack Obama’s second term began in 2013. Nor is extrapolation of rapid earnings growth a significant factor, given that the latest real earnings per share for the S&P index are only 6% above their peak about ten years earlier, before the 2008 financial crisis erupted.”

“The truth is that it is impossible to pin down the full cause of the high price of the US stock market. The lack of any clear justification for its high CAPE ratio should remind all investors of the importance of diversification, and that the overall US stock market should not be given too much weight in a portfolio.”

However, if US selloffs continue to be replicated in other markets, the US may retain its relative high, but hopefully not its historic high.

As tempting as it would be to justify investing against proven trends, country diversification could well be one simple response that is also prudent in a well-diversified portfolio.

(For an interactive analysis of CAPE ratios over time and for many countries, see this link).

 

Vinay Kolhatkar is Assistant Editor at Cuffelinks. This article is general information and does not consider the circumstances of any investor.

 

  •   7 February 2018
  • 2
  •      
  •   

RELATED ARTICLES

Why it's a frothy market but not a bubble

banner

Most viewed in recent weeks

Will you run out of money in retirement?

Fear of running out has become a defining retirement anxiety. Why do some retirees die with substantial wealth while others deplete their nest egg? Evidence suggests the answer is more complicated than we think. 

Why spending more in early retirement can improve lifetime income

Conventional wisdom encourages retirees to preserve superannuation. But if those likely to qualify for the Age Pension later in life spend a little more today, it may deliver higher lifetime income and a more stable retirement.

The investment that sidesteps the new tax traps

Tax rules have changed, but many investors are still using yesterday’s strategies. Insurance bonds may offer advantages for those seeking greater control, tax efficiency and certainty about their wealth.

Testamentary trusts have secured the CGT exemption

Treasury’s latest CGT reform draft delivers a win for testamentary trusts and deceased estates, exempting estate-derived gains from the 30% floor. However, questions on death and divorce rollovers remain unresolved.

Meg on SMSFs: What do we think about reversionary pensions these days?

Reversionary pensions have long been a staple of SMSF estate planning, but are they still the best option? Meg Heffron revisits a once-clear favourite and asks whether changing super rules have shifted the balance.

How does the 4% rule stack up?

The 4% rule has long been retirement's gold standard. But after a difficult period for investors, fresh analysis suggests a more conservative approach may significantly improve the chances of making savings last.

Latest Updates

Planning

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

Investment strategies

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

Economy

Population growth masks Australia’s productivity problem

For years, investors have benefited from a seemingly reliable growth story. But recent national accounts raise uncomfortable questions about what has really been driving Australia’s economy and whether that can continue unchecked.

Investment strategies

Why tomorrow’s winners may not be today’s index leaders

The stocks that built retirement balances over the past decade now dominate many portfolios. The new challenge is whether these companies can continue meeting the increasingly high expectations embedded in today's share prices.

Investing

What earnings surprises reveal about future returns

Sometimes the most important information in an earnings result isn't the number itself. It's the possibility that the market's assumptions have been fundamentally wrong and future earnings may look very different.

SMSF strategies

Individual SMSF Trusteeship directly liable for ATO fines

A rarely discussed detail buried in SMSF structures could dramatically change who wears the cost when something goes wrong. With penalties rising, a decision many dismissed as administrative may deserve a second look.

Investment strategies

The currency bet you didn’t know you made

Buying global shares means making two bets: on the companies and on the Australian dollar. Most investors consciously choose only the first. Last financial year, the second bet cost 8.5% in returns for many investors.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.