Shiller PE (CAPE Ratio)

Shiller PE Ratio vs. Traditional P/E Ratio: What is the Difference?

The difference between the Shiller P/E ratio and the traditional P/E ratio is the time period covered in the numerator, as we mentioned earlier.

In the following section, we’ll discuss the reason that the traditional P/E ratio can be deceiving to investors at times.

The drawback to the traditional P/E ratio comes down to the concept of cyclicality, which describes the fluctuations in economic activity over time.

Certain sectors might be less prone to the negative effects of cyclicality, i.e. “defensive” sectors,” but the recurring pattern of periods of economic expansion and contraction are natural and, for the most part, inevitable in a free market.

• Economic Expansion → Suppose the S&P 500 is currently in a phase of economic expansion, where corporations are reporting strong earnings and beating market expectations. Because the denominator, i.e. the earnings of the companies, is higher, the P/E ratio on an annual basis artificially declines.
• Economic Contraction → On the other hand, if the S&P 500 is undergoing an economic contraction and the economy is on the verge of entering a recession, the earnings of companies would be underwhelming. The impact on the P/E ratio is the reverse as in the prior scenario, as the lower earnings in the denominator can cause an artificially higher P/E ratio.

Hence, companies that are barely profitable often exhibit P/E ratios so high that usage of the metric is not informative. But by no means does the high P/E ratio necessarily signal that the company in question is currently overvalued by the market.

The solution offered by the Shiller P/E ratio is to bypass these cyclical periods by calculating the historical ten-year average, with the proper adjustments made to account for the effects of inflation.

Average vs. Trends in Earnings Per Share (EPS)

While Professor Robert Shiller may be credited for formally presenting the metric to the Federal Reserve and using it in academia, the concept of using a “normalized”, average figure for the earnings metric was not a novel idea.

For instance, Benjamin Graham recommended the necessity to use an average of past earnings in his book, Security Analysis. Graham emphasized that tracking recent trends can be informative yet insufficient by itself to make an investment decision, i.e. the long-term “bigger picture” must also be understood to avoid mistakes related to only looking at short-term cyclical patterns.

What are the Limitations to the CAPE Ratio?

There are many vocal critics of the Shiller P/E ratio, who point to the following shortcomings:

• Overly-Conservative: In general, the most common theme tends to be that the ratio is too conservative, while others cite that trait as one of the main reasons to track it.
• Backward-Looking: Given the calculation is backward-looking, many practitioners and those in academia view the ratio as impractical for forecasting future market performance.
• Accrual Accounting Drawbacks (GAAP): Another source of criticism is the reliance on earnings per share (EPS), which is calculated using net income, i.e. the accounting profits of a company in accordance with the Generally Accepted Accounting Principles (GAAP).
• Prudence Principle: Per GAAP accounting standards, the prudence concept dictates that a company’s financial statements are required to be conservative with regard to not overestimating revenue while not understating its costs.
• Lagging Indicator: Therefore, many perceive the CAPE ratio as a lagging market indicator that is better suited for understanding the past and current market sentiment, yet not a reliable predictor of future market performance (i.e. bear market or bull market).
• Changing Rules and Norms: Not to mention, accounting rules change over time, as well as corporate actions (e.g. the prevalence of stock buybacks in the modern day).

Note: Profession Shiller has released more alternative data sets in response (Source: Yale Economics Online Data)

S&P 500 Shiller PE Index Chart by Month

^{S&P 500 Shiller Index by Month (Source: NASDAQ Data)}