Academic Insights on Investing

Weekly Academic Insight: A New Look of the Shiller CAPE Ratio

TITLE:            The Shiller CAPE Ratio: A New Look        

Authors:          Jeremy J. Siegel

Publication:    Financial Analysts Journal Volume 72 · Number 3 ©2016 CFA Institute

#Research Question:   Are current forecasts of future equity returns using the Shiller CAPE ratio overly pessimistic as a result of changes in the computation of GAAP earnings that are used in the model?  Over the recent two decades, the calculation of corporate earnings has undergone changes that required companies to essentially employ “mark-to-market” mandates in reporting.   As a result of the application of increasingly conservative accounting standards in  S&P500 reported earnings, the CAPE ratio itself is biased upward while forecasts of stock returns are biased downward.

#Academic Insight:    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 is improved and forecasts of US equity returns increase significantly.

#Application:   The CAPE ratio is a recognized predictor of long-term stock returns. However, accurate utilization of the CAPE model requires that the earnings data used are consistent and uniform over time.  The reported earnings calculated by S&P does not meet this requirement.  In order to improve explanatory power and obtain unbiased predictions (that is, avoid downward bias) a measure such as the corporate NIPA (National Income and Product Accounts) earnings should be used.  The Bureau of Economic Analysis (BEA) constructs the national income and product accounts (NIPAs).