Why The CAPE Ratio Isn't A Silver Bullet

The “CAPE” Ratio — or Cyclically Adjusted Price/Earnings Ratio — has gained attention in recent years, and many commentators have recently pointed to the ratio as a reason that stocks are overvalued. (The current CAPE of almost 24 is about 50% above the long-term average of about 16.) But is the CAPE level in and of itself reason to make investing decisions?

No, says hedge fund manager and CNNMoney columnist Jeff Westmont. “While the CAPE ratio can be useful in valuing the stock market, it is misleading to exclusively rely on this metric to determine the attractiveness of stocks,” he writes on CNNMoney.com. “Current and expected earnings, earnings yields versus bond yields and free cash flow yields are more important in determining the relative attractiveness of the stock market.”

Westmont offers nine reasons that you shouldn’t rely on the CAPE alone. Among them:

  • The CAPE Ratio doesn’t take into account how interest rate levels are impacting the attractiveness of stocks and other asset classes;
  • The ten-year period used to calculate the CAPE is “an arbitrary one since it might include two recessions during some periods (which is true today for the current CAPE ratio) and only one or none during other time frames.”

  • The long-term CAPE average of 16 may be misleading. It uses market data going back to 1880, “yet it is unlikely that historical data is directly comparable, since accounting and reporting standards and the stock market structure and liquidity are very different today,” Westmont says.

Westmont says that while it’s true that periods when the CAPE has been below its historical average have been good times to buy stocks, the opposite isn’t true. “There are numerous examples where the CAPE ratio was above the mean (or even above 20x) and the subsequent 10-year returns were strong,” he says. “Thus investors cannot always accept as gospel that an above average CAPE ratio indicates the market is overvalued and subject to a correction when the historical reality is that future returns are, on average, significantly lower yet still positive.”

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