{"id":20427,"date":"2020-01-19T11:33:38","date_gmt":"2020-01-19T11:33:38","guid":{"rendered":"https:\/\/traders-paradise.com\/magazine\/?p=20427"},"modified":"2020-04-03T16:50:56","modified_gmt":"2020-04-03T15:50:56","slug":"cape-ratio-shiller-ratio","status":"publish","type":"post","link":"https:\/\/traders-paradise.com\/magazine\/2020\/01\/cape-ratio-shiller-ratio\/","title":{"rendered":"CAPE Ratio Or The Shiller PE Ratio"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_74 counter-hierarchy ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">Table of Contents<\/p>\n<span class=\"ez-toc-title-toggle\"><a href=\"#\" class=\"ez-toc-pull-right ez-toc-btn ez-toc-btn-xs ez-toc-btn-default ez-toc-toggle\" aria-label=\"Toggle Table of Content\"><span class=\"ez-toc-js-icon-con\"><span class=\"\"><span class=\"eztoc-hide\" style=\"display:none;\">Toggle<\/span><span class=\"ez-toc-icon-toggle-span\"><svg style=\"fill: #999;color:#999\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" class=\"list-377408\" width=\"20px\" height=\"20px\" viewBox=\"0 0 24 24\" fill=\"none\"><path d=\"M6 6H4v2h2V6zm14 0H8v2h12V6zM4 11h2v2H4v-2zm16 0H8v2h12v-2zM4 16h2v2H4v-2zm16 0H8v2h12v-2z\" fill=\"currentColor\"><\/path><\/svg><svg style=\"fill: #999;color:#999\" class=\"arrow-unsorted-368013\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" width=\"10px\" height=\"10px\" viewBox=\"0 0 24 24\" version=\"1.2\" baseProfile=\"tiny\"><path d=\"M18.2 9.3l-6.2-6.3-6.2 6.3c-.2.2-.3.4-.3.7s.1.5.3.7c.2.2.4.3.7.3h11c.3 0 .5-.1.7-.3.2-.2.3-.5.3-.7s-.1-.5-.3-.7zM5.8 14.7l6.2 6.3 6.2-6.3c.2-.2.3-.5.3-.7s-.1-.5-.3-.7c-.2-.2-.4-.3-.7-.3h-11c-.3 0-.5.1-.7.3-.2.2-.3.5-.3.7s.1.5.3.7z\"\/><\/svg><\/span><\/span><\/span><\/a><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><ul class='ez-toc-list-level-4' ><li class='ez-toc-heading-level-4'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/traders-paradise.com\/magazine\/2020\/01\/cape-ratio-shiller-ratio\/#The_CAPE_ratio_has_some_predictive_ability_so_you_can_create_your_investment_strategy_based_on_the_CAPE\" >The CAPE ratio has some predictive ability so you can create your investment strategy based on the CAPE.<\/a><\/li><\/ul><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/traders-paradise.com\/magazine\/2020\/01\/cape-ratio-shiller-ratio\/#How_to_calculate_the_CAPE_ratio\" >How to calculate the CAPE ratio?<\/a><ul class='ez-toc-list-level-4' ><li class='ez-toc-heading-level-4'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/traders-paradise.com\/magazine\/2020\/01\/cape-ratio-shiller-ratio\/#CAPE_RATIO_PRICE_AVERAGE_EARNINGS_ADJUSTED_FOR_INFLATION\" >CAPE RATIO = PRICE \/ AVERAGE EARNINGS ADJUSTED FOR INFLATION<\/a><\/li><\/ul><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/traders-paradise.com\/magazine\/2020\/01\/cape-ratio-shiller-ratio\/#Lets_use_CAPE\" >Let&#8217;s use CAPE<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/traders-paradise.com\/magazine\/2020\/01\/cape-ratio-shiller-ratio\/#How_the_CAPE_Ratio_Works\" >How the CAPE Ratio Works\u00a0<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-6\" href=\"https:\/\/traders-paradise.com\/magazine\/2020\/01\/cape-ratio-shiller-ratio\/#Ability_of_Forecasting\" >Ability of Forecasting<\/a><ul class='ez-toc-list-level-4' ><li class='ez-toc-heading-level-4'><a class=\"ez-toc-link ez-toc-heading-7\" href=\"https:\/\/traders-paradise.com\/magazine\/2020\/01\/cape-ratio-shiller-ratio\/#Bottom_line\" >Bottom line<\/a><\/li><\/ul><\/li><\/ul><\/nav><\/div>\n<h4><span class=\"ez-toc-section\" id=\"The_CAPE_ratio_has_some_predictive_ability_so_you_can_create_your_investment_strategy_based_on_the_CAPE\"><\/span><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-20428 size-full\" src=\"https:\/\/traders-paradise.com\/magazine\/wp-content\/uploads\/2020\/01\/CAPE-ratio-t-1.jpg\" alt=\"CAPE Ratio Or The Shiller PE Ratio\" width=\"800\" height=\"533\" srcset=\"https:\/\/traders-paradise.com\/magazine\/wp-content\/uploads\/2020\/01\/CAPE-ratio-t-1.jpg 800w, https:\/\/traders-paradise.com\/magazine\/wp-content\/uploads\/2020\/01\/CAPE-ratio-t-1-300x200.jpg 300w, https:\/\/traders-paradise.com\/magazine\/wp-content\/uploads\/2020\/01\/CAPE-ratio-t-1-768x512.jpg 768w, https:\/\/traders-paradise.com\/magazine\/wp-content\/uploads\/2020\/01\/CAPE-ratio-t-1-370x247.jpg 370w, https:\/\/traders-paradise.com\/magazine\/wp-content\/uploads\/2020\/01\/CAPE-ratio-t-1-760x506.jpg 760w, https:\/\/traders-paradise.com\/magazine\/wp-content\/uploads\/2020\/01\/CAPE-ratio-t-1-424x282.jpg 424w\" sizes=\"auto, (max-width: 800px) 100vw, 800px\" \/><br \/>\n<strong>The CAPE ratio has some predictive ability so you can create your investment strategy based on the CAPE.<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h4>\n<p><span style=\"font-weight: 400;\">The CAPE ratio is a variety of the P\/E ratio. Just like the <\/span><a href=\"https:\/\/traders-paradise.com\/magazine\/trading-dictionary\/p\/p-e-ratio\/\"><span style=\"font-weight: 400;\">P\/E ratio<\/span><\/a><span style=\"font-weight: 400;\">, the CAPE ratio shows whether a stock price is undervalued, overvalued, or fairly valued.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">But, the CAPE ratio permits the evaluation of a company\u2019s profitability during various periods of an economic cycle. The CAPE ratio also analyses economic fluctuations, both the economy\u2019s expansion and recession. Basically, the CAPE ratio is a tool analysts use to measure how &#8216;cheap&#8217; or &#8216;expensive&#8217; the stock market is. We can know that only if we compare its P\/E ratio with historical values over the last 10 years, that is common. And if the P\/E ratio of the market is lower than it&#8217;s 10-years average we can say the market is undervalued. Hence, if the 10-years average is higher, the market is overvalued.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">This metric to estimate if the stock market is overvalued or undervalued was developed by <\/span><a href=\"https:\/\/en.wikipedia.org\/wiki\/Robert_J._Shiller\"><span style=\"font-weight: 400;\">Robert Shiller<\/span><\/a><span style=\"font-weight: 400;\">, an American Nobel Prize Laureate in economics. It became very popular during the Dotcom Bubble. At that time Shiller perfectly pointed out that equities were extremely overvalued. That&#8217;s why this metric is also called Shiller PE.<\/span><\/p>\n<h3><span class=\"ez-toc-section\" id=\"How_to_calculate_the_CAPE_ratio\"><\/span><b>How to calculate the CAPE ratio?<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p><span style=\"font-weight: 400;\">It is possible if you divide the current market price by the 10-year average of inflation-adjusted earnings per share.\u00a0<\/span><\/p>\n<h4><span class=\"ez-toc-section\" id=\"CAPE_RATIO_PRICE_AVERAGE_EARNINGS_ADJUSTED_FOR_INFLATION\"><\/span><b>CAPE RATIO = PRICE \/ AVERAGE EARNINGS ADJUSTED FOR INFLATION<\/b><span class=\"ez-toc-section-end\"><\/span><\/h4>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">That&#8217;s a big bite, so lets this formula to make a bit simpler.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Let&#8217;s say, some farmer is selling apples for $20 each. WOW! This guy may make a fortune. But who will pay $20 for just one apple? Is it golden? Everyone would think the price is insane. But let&#8217;s take a look at historical data for the last 10 years. For example, we found one single apple has been selling at $40 over the past 10 years. This would change your opinion and we suddenly believe the price of $20 isn&#8217;t high, it is contrary, very cheap. Something different we would believe if we found the apple average price was $2 over the last 10 years. Who would buy now?\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">So, we estimated what was the average apple price in 10 years to have a comprehensive idea of how much apple costs.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Let&#8217;s this example apply to the stock market which has a historical price called a P\/E.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">P\/E is when the price per share is divided by the earnings per share each year. If the farmer mentioned above started a company and makes $2 a share and the stock market values each share of the company at $10, what would the P\/E ratio be? The P\/E would be 5.<\/span><\/p>\n<h3><span class=\"ez-toc-section\" id=\"Lets_use_CAPE\"><\/span><b>Let&#8217;s use CAPE<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p><span style=\"font-weight: 400;\">If the CAPE ratio is extremely high, which means that we have a company with a higher stock price than the company\u2019s earnings show. So we would easily conclude that the stock of such a company is overvalued. Of course, we can expect that the market will ultimately correct the stock price by shifting it down to its fair value.<\/span><\/p>\n<h3><span class=\"ez-toc-section\" id=\"How_the_CAPE_Ratio_Works\"><\/span><b>How the CAPE Ratio Works<\/b><span style=\"font-weight: 400;\">\u00a0<\/span><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p><span style=\"font-weight: 400;\">A good position for following the CAPE ratio is to estimate the basic P\/E ratio as first. It is a generally-accepted metric, but Shiller noticed a restriction in it.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Well, a company\u2019s earnings can be reasonably volatile from year to year particularly during top and not so good years in a business cycle. To have accurate info about some company we have to minimize the effect of the short-term business cycle on the valuation. That was the problem that Shiller noticed. Instead of looking at just one year, he created the ratio that takes into consideration the average earnings over the past 10 years. This provides comparing valuations over a longer period of time.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">One disadvantage of the popular P\/E ratio is that it is related to the past 12-months earnings only. But what if something temporary happens during that period? For instance, a big store-chain has to close some of them for restoring them. That would reduce the earning for sure but the company finished what was planned and made progress in earnings. But you didn&#8217;t buy a share of that company just because you made your decision based only on one metric &#8211; P\/E ratio. And you missed the profit. By using the CAPE ratio you would be able to make <\/span><span style=\"font-weight: 400;\">a better choice<\/span><span style=\"font-weight: 400;\">.<\/span><\/p>\n<h3><span class=\"ez-toc-section\" id=\"Ability_of_Forecasting\"><\/span><b>Ability of Forecasting<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p><span style=\"font-weight: 400;\">The CAPE ratio showed its importance in recognizing possible bubbles and market crashes. It was determined that the historical average of the ratio for the S&amp;P 500 Index was inside 15 and 16. The maximum levels of the ratio passed 30. The record-high levels occurred several times. The first was in 1929 before the Wall Street crash that flagged the Great Depression. The second occurred in the late 1990s and announced the Dotcom Crash. Also, we had <\/span><a href=\"https:\/\/traders-paradise.com\/magazine\/2019\/08\/predict-stock-market-movements\/\"><span style=\"font-weight: 400;\">signals<\/span><\/a><span style=\"font-weight: 400;\"> before the 2007-2008 Financial Crisis.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Speaking about investors and investments, there is held to be a relationship between the CAPE ratio and <\/span><span style=\"font-weight: 400;\">future earnings<\/span><span style=\"font-weight: 400;\">. Shiller noticed that lower ratios give higher returns for investors over time.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Nevertheless, there are critiques regarding the use of the CAPE ratio in predicting earnings. The main problem is that the CAPE ratio does not calculate the moves in accounting reporting rules. For example, what if changes in the calculation of earnings under the GAAP appear? That could change the ratio and present a pessimistic sense of <\/span><span style=\"font-weight: 400;\">future earnings<\/span><span style=\"font-weight: 400;\">.<\/span><\/p>\n<h4><span class=\"ez-toc-section\" id=\"Bottom_line\"><\/span><b>Bottom line<\/b><span class=\"ez-toc-section-end\"><\/span><\/h4>\n<p><span style=\"font-weight: 400;\">The CAPE isn&#8217;t the only metric you should use when investing but of course, it is one of.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">It\u2019s mostly used to the S&amp;P 500, but can be applied to any stock index. The advantage is that it is one of several valuation metrics that can help you. It is important to find the current relationship between the price you pay for stock and future earnings. <\/span><span style=\"font-weight: 400;\">If the CAPE is high, and other measures are high, it is a good idea to cut your stock exposure. Also, you can invest in <\/span><a href=\"https:\/\/traders-paradise.com\/magazine\/2020\/01\/microcap-stocks-recognize-risks-and-get-rewards\/\"><span style=\"font-weight: 400;\">something cheaper<\/span><\/a><span style=\"font-weight: 400;\">.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">A savvy investor should always compare the price that pays and the value that gets. <\/span><span style=\"font-weight: 400;\">Regularly, all investors want to buy a company when its stock is trading at a low P\/E ratio. That will give them a better profit.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">But that could be the problem too. When a recession, the stock will fall. At the same time, the company&#8217;s earnings will fall, and that can quickly raise the P\/E ratio. But it is temporary. The consequence is that we are receiving a false signal that the market is expensive. And what we are doing? We don&#8217;t buy the stock when certainly it\u2019s the best time to buy it. And here is the point where the CAPE ratio is fully useful.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">It shows a more realistic relationship between current prices and earnings based on 10-years average adjusted for inflation over the latest business cycle.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">When you are choosing which assets to sell, CAPE can be a great support. If you see that CAPE shows the S&amp;P 500 is undervalued, sell bonds. And when CAPE shows the S&amp;P 500 is overvalued, sell those holdings first.<\/span><\/p>\n","protected":false},"excerpt":{"rendered":"<p>The CAPE ratio has some predictive ability so you can create your investment strategy based on the CAPE. The CAPE ratio is a variety of the P\/E ratio. Just like the P\/E ratio, the CAPE ratio shows whether a stock price is undervalued, overvalued, or fairly valued.\u00a0 But, the CAPE ratio permits the evaluation of [&hellip;]<\/p>\n","protected":false},"author":4,"featured_media":20429,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"content-type":"","_exactmetrics_skip_tracking":false,"_exactmetrics_sitenote_active":false,"_exactmetrics_sitenote_note":"","_exactmetrics_sitenote_category":0,"footnotes":""},"categories":[1016,1012],"tags":[1553,1552,1556,1554,1555],"class_list":["post-20427","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-how-to-master-in-trading-advanced","category-traders-secrets","tag-cape","tag-cape-ratio","tag-p-e-ratio","tag-robert-shiller","tag-valuation"],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v25.1 - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>CAPE Ratio Or The 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