Comparing CAPE 10 with CAPE 5 or 6 — Market May Not be as Expensive as it Looks

Writing on ETF.com, Larry Swedroe of the BAM Alliance explains that the market looks less overvalued if one uses a period shorter than the commonly used 10-year period in applying the methodology of the Shiller cyclically adjusted P/E ratio (the CAPE 10). The reason for doing this is that “with the Great Recession causing the S&P 500 earnings to not recover to their 2007 level until 2010,” a 10-year period may include distortions created by the financial crisis. Further “there is nothing magical about using 10 years to calculate average earnings.” Indeed, in Benjamin Graham and David Dodd’s 1934 book “Security Analysis,” which “recommended dividing price by a multiyear average of earnings,” they “suggested using a five- or seven-year period,” as well as the 10-year period that John Campbell and Robert Shiller’s 1988 work popularized. Running the data, Swedroe concludes “if we make an adjustment from CAPE 10 to a CAPE 6 or CAPE 5, and we still use a very long period of 56 years [to calculate the long-term mean] and operating earnings, we find current valuation of the market is less than 20% above its mean,” which is “a dramatically lower than the 57% difference between the current CAPE 10 and its long-term average.” Further, this “doesn’t consider adjustments for . . . changes in accounting rules, reduction in the tendency to pay dividends and the dramatic fall in transaction costs.” These considerations, as well as the use of a 1960-to-present rather than 1880-present long-term average, are relevant because changes in conditions shaping the market and economy (such as regulation and technology) can significantly affect earnings and/or valuations. “The bottom line,” according to Swedroe, “is that once those adjustments are considered, there’s a case to be made that the market no longer looks overvalued.”