What Is the CAPE Ratio? Shiller PE Explained

The cyclically adjusted price-to-earnings ratio — known as the CAPE ratio or Shiller PE, after Nobel Prize-winning economist Robert Shiller — is the most widely followed gauge of overall stock market valuation. When Barron's or the Wall Street Journal reports that "the market is expensive," they're usually referencing this metric. It smooths out the earnings cycle to give a clearer picture of whether stocks are cheap, fairly priced, or expensive relative to history.

Understanding the CAPE ratio helps investors set realistic expectations for future returns and avoid the mistake of buying aggressively when valuations are at extremes.

How It Works

The standard PE ratio divides a stock's price by its most recent year of earnings. The problem is that earnings fluctuate wildly with the business cycle — they surge during booms and collapse during recessions. A PE ratio calculated at the bottom of a recession, when earnings are temporarily depressed, makes the market look expensive even if stocks are actually cheap. Conversely, a PE calculated at the peak of a boom can make the market look cheap right before a crash.

The CAPE ratio solves this by averaging ten years of inflation-adjusted earnings in the denominator. This decade-long average smooths out temporary earnings peaks and troughs, giving you a valuation measure based on the economy's underlying earning power rather than a single year that might be anomalously high or low.

To calculate the CAPE ratio for the S&P 500: take the current index price, divide it by the average of the past ten years of real (inflation-adjusted) earnings per share. The result tells you how much investors are paying per dollar of normalized corporate earnings.

What the CAPE Tells You About Future Returns

The CAPE ratio's most powerful use is as a long-term return forecaster. Historically, high CAPE readings have been followed by below-average ten-year returns, and low CAPE readings have been followed by above-average ten-year returns. This relationship isn't precise enough for market timing, but it's strong enough to set reasonable expectations.

The long-term average CAPE for the S&P 500 is roughly 17. When the CAPE is well above this level — say, above 25 — future ten-year returns have historically been modest, often in the low single digits. When the CAPE is below 15, subsequent ten-year returns have historically been strong, frequently exceeding 10% annually. The ratio reached 44 at the peak of the dot-com bubble in 2000, after which the market delivered negative real returns for a decade.

It's critical to note that the CAPE tells you almost nothing about the next one to two years. Expensive markets can keep getting more expensive for years before mean-reverting. The CAPE first crossed 25 in 1996, and anyone who sold then missed four more years of gains before the crash. As a short-term timing tool, the CAPE is nearly useless. As a long-term expectations tool, it's among the best available.

Limitations and Criticisms

The most common criticism is that the CAPE's ten-year earnings window can include periods that are no longer relevant. After the 2008-2009 financial crisis, the deeply depressed earnings from those years dragged down the ten-year average, making the CAPE appear elevated even as forward earnings were strong. Critics argue this produced a misleadingly expensive reading for years after the crisis.

Structural changes in the economy may justify a higher average CAPE than in prior decades. Technology companies — which dominate today's market — have higher margins, lower capital requirements, and more scalable business models than the industrial economy of the mid-20th century. If companies are genuinely earning more per dollar of assets than they used to, paying more for those earnings makes economic sense.

Changes in accounting standards, share buyback activity, and the composition of the S&P 500 also affect historical comparisons. Today's S&P 500 is more heavily weighted toward capital-light, high-margin businesses than at any point in history. Comparing today's CAPE to the CAPE of the 1950s — when the index was dominated by industrial conglomerates — requires nuance.

How to Use the CAPE Practically

We use the CAPE to calibrate expectations, not to time the market. When the CAPE is elevated, expect lower future returns and position accordingly — perhaps saving more, reducing speculative positions, or ensuring your portfolio emphasizes high-quality businesses that can grow regardless of market-level returns. When the CAPE is low, lean into equities with confidence that history favors attractive long-term returns.

Apply the CAPE to compare markets geographically. International markets often trade at significantly lower CAPE ratios than the U.S. market. This valuation gap doesn't guarantee international outperformance, but it does suggest that international stocks offer more return per dollar of earnings, which may justify increasing your international allocation when the gap is wide.

For individual stock analysis, the CAPE concept translates as a preference for looking at multi-year average earnings rather than a single year. A company's PE ratio based on one unusually good year can be deceptive. Calculating a price-to-average-earnings ratio over five or ten years gives you a more honest assessment of what you're paying for the business's underlying earning power.