Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overpessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly.


The Shiller CAPE Ratio: A New Look

Read the Full Report (PDF)

Abstract

Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overpessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly.

What’s Inside?

The author argues that the use of GAAP earnings, which includes mark-to-market requirements, artificially inflates the cyclically adjusted price/earnings ratio (CAPE ratio), which leads to lower forecasts of real stock returns. GAAP earnings are the basis of Standards & Poor’s reported earnings, which are used to compute the CAPE ratio. The reported earnings series computed by Standard & Poor’s does not observe consistent and uniform standards across time, mainly because there have been significant changes in US accounting practices since 1993. The author shows that substituting national income and product account (NIPA) after-tax corporate profits for GAAP earnings leads to an improvement in the forecasting ability of the CAPE model.

How Is This Research Useful to Practitioners?

The CAPE ratio, created by Robert Shiller, is one of the best-known models for forecasting long-term real stock returns. The model regresses the forward 10-year annualized real stock return on the current value of the CAPE ratio. The ratio is based on the arithmetic average of the last 10 years of S&P 500 Index reported earnings per share. With a coefficient of determination of 35% and a significant coefficient on the CAPE ratio, the author finds that the CAPE ratio explains more than one-third of the movement of stock returns.

The author argues that the rise in the CAPE ratio in recent years is the result of changes in accounting standards that affect reported earnings. He suggests using NIPA corporate profits because, contrary to the definition of GAAP earnings, the definition of NIPA corporate profits has not changed over time. The author shows that over the past two decades, there have been much sharper declines in S&P reported earnings than in NIPA corporate profits. The high volatility in the S&P reported earnings is driven by, among other things, asset write-downs taken by several financial companies during the recent financial crisis.

Using NIPA corporate profits rather than S&P reported earnings reduces the CAPE ratio and the level of equity market overvaluation and increases the projected stock returns. The author notes that long-term stock returns are mean reverting; thus, when the CAPE ratio is above its long-run average, the model predicts below-average real stock returns for the following 10 years.

How Did the Authors Conduct This Research?

The author performs regressions on the CAPE ratio using three measures of earnings. He plots the CAPE ratio from 1881 through 2014, which shows that the model explains about one-third of the movement in future 10-year real stock returns. He also plots after-tax per share earnings for S&P reported earnings, S&P operating earnings, and NIPA real after-tax corporate profits as published in the NIPAs. The latter plot shows that sharp declines of S&P reported earnings have increased significantly since 1991.

To show that the volatility of S&P reported earnings has increased significantly in the last three business cycles, the author reports earnings declines in recessions from 1929 to 2014. In the last three recessions (1990, 2001, and 2008–2009), S&P reported earnings decreased by more than twice as much as NIPA corporate profits. The author points out that the change in the computation of S&P reported earnings has resulted in a shift from understating earnings declines during economic downturns to significantly overstating them.

The author concludes that using NIPA corporate profits instead of the S&P reported earnings produces higher projected stock market returns.

Abstractor’s Viewpoint

The CAPE ratio is used by finance practitioners in an attempt to gauge the S&P 500’s level of valuation. The author convincingly argues that changes in US accounting standards have led to an overstatement of earnings declines in recessions and an artificially high CAPE ratio. Given the current popularity of the CAPE ratio by finance practitioners and the media, the author’s research demonstrates that further analysis is required to successfully use this ratio for investment purposes.

Editor's note: The article was reviewed and accepted by Executive Editor Robert Litterman.

Author Information

Jeremy J. Siegel

Jeremy J. Siegel is the Russell E. Palmer Professor of Finance at the Wharton School, University of Pennsylvania, Philadelphia.

References

Additional Information

Published by CFA Institute

https://doi.org/10.2469/faj.v72.n3.1