The Shiller PE (CAPE) Ratio: Predicting Market Crashes and “Lost Decades”
The Shiller PE (CAPE) Ratio: Predicting Market Crashes and “Lost Decades”
COACHING POINTS
- The Problem: Standard P/E ratios are volatile. In a recession, earnings collapse, making the P/E look artificially high. In a boom, earnings spike, making stocks look artificially cheap. This misleads investors.
- The Solution: The Shiller PE (CAPE) divides the price by the average of the last 10 years of earnings (adjusted for inflation). This smooths out the business cycle to reveal the true valuation of the market.
- The Signal: Historically, when the CAPE Ratio exceeds 30, future 10-year returns tend to be zero or negative (a “Lost Decade”). When CAPE is below 15, future returns are typically massive.
“Buy low, sell high” is impossible if you don’t know what “high” is. Nobel Laureate Robert Shiller developed the CAPE (Cyclically Adjusted Price-to-Earnings) Ratio to gauge whether the stock market is priced for perfection or priced for disaster. It is arguably the single best predictor of long-term market returns. Source: Yale University / Robert Shiller Data
The math of CAPE is simple: Valuation acts like gravity on future returns.
- Scenario A (1999 Dotcom Bubble):
CAPE Ratio: 44 (Historic High).
Result: The S&P 500 returned -0.9% per year for the next 10 years. (Lost Decade). - Scenario B (2009 Financial Crisis):
CAPE Ratio: 13 (Historic Low).
Result: The S&P 500 returned +16% per year for the next 10 years. (Golden Decade). - The Lesson: If you buy when the CAPE is high, you are essentially pre-paying for future growth. You eat the returns before they happen.
What-If Scenario: Investing at CAPE 35
Comparison: Lump Sum investing at high valuation vs. mean reversion.
| Starting Valuation | Historical 10-Year Real Return | Outcome |
|---|---|---|
| CAPE < 15 (Cheap) | +10% to +15% | Wealth Compounding |
| CAPE > 30 (Expensive) | -2% to +3% | Wealth Stagnation |
CAPE vs. Future 10-Year Returns
| CAPE Level | Avg Annual Return (Next 10Y) |
|---|---|
| Cheap (10-15) | 13 |
| Fair (15-20) | 7 |
| Expensive (25+) | 2 |
*There is a strong inverse correlation. High valuations today mathematically imply lower returns tomorrow.
History’s Biggest Bubbles (CAPE Score)
| Market Peak | CAPE Ratio |
|---|---|
| 1929 (Great Crash) | 32 |
| 2000 (Dotcom Bubble) | 44 |
| 2021 (Post-COVID) | 38 |
*Every time the CAPE ratio spiked above 30, a significant market correction or a period of stagnation followed.
Execution Protocol
Visit a resource like Shiller’s data page or Multpl.com. If the S&P 500 CAPE is above 30, acknowledge that US Stocks are “expensive.” Do not expect 10% returns for the next decade.
When the US CAPE is 35, the Emerging Markets CAPE might be 12. Valuation differences are a primary reason to hold International stocks (#48). They may offer better expected returns simply because they are cheaper.
Within the US market, Growth stocks usually drive the high CAPE. Value stocks (low P/E) often trade at more reasonable multiples. Tilting your portfolio toward Value (#334) can reduce your exposure to a valuation crash.
COACHING DIRECTIVE
- Do This: Use CAPE to adjust your savings rate. If CAPE is high, you must save more money to reach your goal, because the market will likely help you less.
- Avoid This: Selling everything because CAPE is high. The market can remain irrational longer than you can remain solvent (e.g., 1996-2000). Use it for expectation setting, not market timing.
Frequently Asked Questions
Is “This Time Different”?
Critics argue that accounting rules (GAAP) and tech profit margins have changed, justifying a permanently higher CAPE. While partially true, mean reversion is a powerful force that usually wins eventually.
What is a “Lost Decade”?
A period where the stock market delivers 0% or negative real returns. The US experienced this from 2000-2009 and 1966-1982. It usually happens after a period of extreme overvaluation.
How does inflation affect CAPE?
CAPE is inflation-adjusted by design. However, high inflation periods (like the 1970s) crush P/E multiples, often driving the CAPE ratio down into the single digits.