One of the valuation measures of the equity market is the price / earnings ratio. In 2008, the companies of the S&P 500, in aggregate, suffered a significant loss one quarter. It badly distorted the P/E ratio for a year since the earnings part of the ratio is the summation of twelve months.

To avoid this, Robert Shiller proposed in his book *Irrational Exuberance* a new measure called the Cyclically Adjusted Price Earnings Ratio (CAPE Ratio). The idea was to take the price and divide by the average annual earnings over the prior ten years. The calculation is fairly easy since the prior twelve months earnings can be computed each month. Then the average of those earnings over ten years is calculated.

The current PE is 25.53. The historical mean is 16.51 and the historical median is 15.90. The conclusion is the price is high relative to the earnings.

I bring this up not just because I have been seeing this measure frequently, but because I think there is a problem with the calculation.

By my calculation, I have a current CAPE of 27.39 (1845.89 / 67.39). The official measure of 25.53 comes from 1838.63 / 72.03. I can’t explain the difference, but I don’t know the source of the earnings for the official measure. I do know my source (us.spindices.com) and I can see the detail rather than the rolling last twelve months. The two CAPE ratios aren’t too different and will not affect the conclusion and thus, I plow forward.

As I mentioned in the last post, the earnings estimates over the next two years is expected to grow 45%. This will move the denominator of the CAPE from 67.39 to 80.51, an increase of only 20%. If we assume the numerator remains constant, the CAPE ratio decreases from 27.39 to 22.93. The initial conclusion should be that even a remarkably large increase in earnings (45%) over the next two years still will not move the CAPE ratio back between the mean and median.

In thinking about the implications of using a ten-year moving average in earnings and comparing it to a spot point of the price presents a mathematical difficulty. The only way to quickly change the ratio is to change the price. The denominator can only change the ratio over the long-term. The conclusion that a 45% increase in earnings over two years doesn’t significantly impact the ratio shouldn’t be a surprise because it gets muted by the effect of using an average.

Specifically, 2014 replaces 2004 (which means 120.60 replaces 58.55) and 2015 replaces 2005 (which means 147.50 replaces 69.93). What remains is 2006 through 2013 and totals 565.78. The increases forecasted in 2014 and 2015 only add 139.62 net to the total. Spreading that out across a decade really mutes the impact.

My second conclusion is that I am no longer certain what this measure tells me about the market. It puts too much emphasis on the price relative to the earnings. It also doesn’t seem to provide any additional information beyond the traditional PE. It will be useful in case of another time when earnings are affected by a significant change away from the trend, but I will simply hope we can avoid another 2008.