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The Cyclically Adjusted Price/Earnings Ratio (or CAPE) has been getting a lot of attention lately. It was originally developed by Benjamin Graham, and Robert Shiller has been the latest proponent.

In today’s Financial Times, John Authers writes:

Long-term measures of value are also finely poised. Take the cyclical price/earnings ratio, which compares share prices with average earnings during the past decade, rather than to the most recent year's earnings. This evens out bumps in earnings multiples caused by the profit cycle, and has proved to be a great market timing vehicle - highs and lows for this metric have overlapped almost perfectly with highs and lows for the market.

Robert Shiller, the Yale university economist, has done much to popularise the measure. According to his calculations, it makes US stocks look distinctly cheap. The cyclical p/e, at 13.38 entering this week, is below its average since 1870 of 16.34. It is also at its lowest since 1986.

However, this should not be treated as a short-term buying signal because cyclical p/es have dropped to as low as 6 at the bottom of previous bear markets. This would imply that stocks could fall 50 per cent more, before hitting bottom.

I don’t think adjusting earnings multiples for the economic cycle is a sound idea. The obvious reason is that stock prices are themselves cyclical. I dispute Authors points that CAPE has been “a great market timing vehicle.” In fact, I think it’s been pretty bad.

According to data off Professor Shiller’s website, when the market’s CAPE was below 21, the market returned 1.35% annualized and adjusted for inflation. When it was above 21, the market did slightly better, growing by 1.82% annualized and adjusted for inflation.

For the unadjusted 12-month P/E Ratio, the market grew by 1.79% when it was below 21, and it contracted by -1.29% when it was above 21. In other words, the traditional P/E Ratio told you a lot more about how well the market was valued.

Neither metric, however, comes close to the easiest—momentum. If the market fell in the previous month, then it has continued to fall by an annualized and adjusted for inflation rate of -8.36%. If the market has been rising, then it continues to grow by a rate of 10.09%.

Posted by edelfenbein at February 25, 2009 1:40 PM