The CAPE ratio, Cyclically Adjusted Price Earnings ratio, is a version of the price/earnings (PE) ratio popularized by Robert Shiller. It is widely used to assess the richness or cheapness of the equity market relative to its own history, and to make forecasts of the long-run return on equities, a vital input into asset allocation processes and retirement saving and spending plans. Here, I present a method for extracting the equity risk premium from the CAPE and potentially improving its forecast accuracy.
How does the CAPE differ from the ordinary PE ratio? Instead of dividing the current level of the market by one year’s trailing or
forecast earnings to calculate the PE, the CAPE uses 10 years’ trailing real (inflation-adjusted) earnings. Because earnings fluctuate a great deal, taking a 10-year average smooths out the ups and downs, making the CAPE more a well-behaved measure of market levels than the volatile one-year PE.