CAPE

There are three popular P/E ratios:

• Forward P/E (on subsequent 12-month earnings forecasts)
• Trailing 12-month (TTM) P/E (on most recent 12-month past earnings)
• Robert Shiller's Cyclically Adjusted P/E (CAPE)

The CAPE uses earnings from the prior 10 years and has become a widely followed valuation measure. Yale professor Robert Shiller defines the numerator of the CAPE as the real (inflation-adjusted) price level of the S&P 500® Index and the denominator as the moving average of the preceding 10 years of S&P 500 real reported earnings, where the US Consumer Price Index (CPI) is used to adjust for inflation. The purpose of averaging 10 years of real reported earnings is to control for business-cycle effects. The CAPE is also sometimes referred to as the P/E10.

There are several problems with the construction of the CAPE, detailed in a terrific report by Steve Wilcox for The American Association of Individual Investors posted on the Seeking Alpha site in 2011, from which I'll pull some data.

The problem with using a 10-year period for earnings is that the average business cycle only lasts about six years. More recently, recessions have become shorter and expansions longer (notwithstanding the long "Great Recession" which ended in 2009), as you can see in the table below. As a result, CAPE tends to overestimate "true" average earnings during a contraction and underestimate "true" average earnings during an expansion.

In the present bull market, the first month the CAPE crossed into overvalued territory (i.e. went above its median) was May 2009, just two months after the market's bottom, since which time the market has more than doubled. Even more dramatic was the cross into overvalued territory by the CAPE in February 1991, a mere nine years shy of the top of the great 1990s' bull market.