Money

Building a Better CAPE Ratio

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October 5, 2022

After a bit of a hiatus from the blog – thanks to our ambitious summer travel schedule – it’s time for another post. Over the years, I’ve gotten a lot of questions about the Shiller CAPE Ratio and if it’s still relevant. If you’re a regular reader of my blog, you’ll likely be familiar with the CAPE concept, but just as a refresher, Prof. Robert Shiller, economist and Nobel Laureate, came up with the cool idea of calculating a Price-Earnings (PE) ratio based not just on 1-year trailing earnings, which can be very volatile, but on a longer-term average to iron out the corporate earnings fluctuations over the business cycle. Hence the name Cyclically-Adjusted Price Earnings (CAPE) Ratio. If we use a 10-year moving average of inflation-adjusted earnings as the denominator in the PE ratio, we get a measure of market valuations that’s more informative in many instances. For example, historically the CAPE ratio has been significantly negatively correlated with subsequent equity returns. It’s not useful for the very short-term equity outlook, but over longer horizons, say 10+ years, the CAPE ratio has been highly informative. Especially retirees should take notice because your retirement success hinges a lot on those first 10 or so retirement years due to Sequence of Return Risk. In fact, all failures of the 4% Rule occurred when the CAPE was above 20! A high initial CAPE ratio signals that retirees should probably be more cautious with their withdrawal rate!

But the CAPE has been elevated for such a long time, people wonder if this measure is still relevant. In the comments section, people ask me all the time what kind of adjustments I would perform to “fix” the CAPE. Can we make the Shiller CAPE more comparable over time, to account for different corporate tax environments and stock buybacks and/or dividend payout ratios over the decades? Yes, I will present my ideas here today. And even better, I will post regular updates (potentially daily!) in my Google Drive for everyone to access for free.

So, what do I find? The adjustments certainly lower the CAPE, but don’t get your hopes too high. Even after the adjustments, the CAPE is still a bit elevated today! Let’s take a look at the details…

Before we even get started with the tax and dividend payout ratios, here are two additional and crucial adjustments I always like to perform when calculating the Shiller CAPE. I might have mentioned these adjustments in a previous post, but never delved much into the details. But today is a good excuse to do so…

Fixing Shiller’s data lags

First, Shiller operates with woefully outdated data, especially earnings data. That may not be too much of a problem in typical macroeconomic research projects studying many decades worth of data. But the average retiree likes to have a timely and accurate estimate of the CAPE Ratio. Below is a screenshot from the Shiller Excel Sheet posted on his website. I downloaded this file on October 3, 2022. The first thing we notice is that the data are crazy outdated. The rows only go to July 2022 and the index level not even the month-end but July 5, so almost 3 months outdated. Of course, we can still derive a pretty decent estimate of the October 3 Shiller CAPE. For example, if we use an SPX quote of 3678.43 (=index level as of 10/3/2022, market close) and we rescale the 28.90 CAPE to 28.90/3831.39*3678.43 we get a CAPE of 27.75. But that’s not really precise because the July 2022 CAPE ratio uses the average real earnings over the 120 months of July 2012 to June 2022. But for the October 2022 CAPE, we have to use October 2012 to September 2022 average real earnings. We are using 3 months of data we shouldn’t use and are missing 3 months worth of data that we should be using.

http://www.econ.yale.edu/~shiller/data.htm

But the data lag problem is even worse. Shiller’s earnings data go only up to March 2022. So, even back in July, he was 3 months short of earnings data. So, we are inadvertently underestimating the “E” part of the CAPE calculation because we’re putting a weight of 1/117 instead of 1/120 on the (significantly lower) earnings numbers from ten years ago. And using Shiller’s data for an October 2022 CAPE ratio estimate we’re now missing 6 months’ worth of earnings data. Excuse me for being pedantic, but that’s not acceptable.

So, how do I deal with the missing data in the Shiller Sheet? The first problem is easy to solve: I simply download the additional SPX index data for the other months. But what about the earnings data? The problem is that even as of October 3, 2022, the earnings for Q2 are not 100% finalized. According to the index provider, DJ SP Global, that Q2 number is “only” 99.8% final, so there are still 0.2% of the index members that haven’t finalized their number (link to their Excel Sheet).

https://www.spglobal.com/spdji/en/documents/additional-material/sp-500-eps-est.xlsx

Well, 99.8% is obviously good enough. And remember, the 99.8% refers to the current quarter. Shiller uses the 4-quarter moving average, so the estimate for the annual trailing earnings per share (EPS) is really 99.95% finalized as of 10/3/2022. So, I can certainly use the $192.26 estimate for June 2022. (also notice that, just as a quick check, the 197.91 and 197.87 figures for 2022Q1 and 2021Q4 exactly match the Shiller numbers, so he’s getting his numbers from the same source.)

And while we’re at it, I am also using the subsequent earnings forecasts for Q3 as the September EPS number in my table. And just like Shiller, I linearly interpolate the EPS for the months in between. And I concede that these are only forecasts, and sure, the forecasts may be off. But not using the SP Global estimates and effectively using the average over the 114 past months as an estimate for the six missing months is also a forecast and likely one with an even greater error!

In any case, I wrote a little Python program to perform the Shiller CAPE calculations, but instead of using the outdated Shiller EPS data, I access the SP Global data and fill in the missing earnings data and use the earnings estimates of the index provider instead. See the output below:

Precision is important in retirement planning!

And I want to make one thing really clear: I’m not trying to ding Prof. Shiller’s methodology. It may be correct in another context. But for our specific application, using the most recent index value and padding the EPS data with the currently available estimates makes the most sense.

Sorry about the deep dive into the CAPE methodology. For the three to four readers that haven’t fallen asleep yet, let’s talk about the issues mentioned in the intro now. One criticism of the Shiller methodology is that the CAPE has been elevated for such a long time. It seems that a CAPE ratio in the high-20s in today’s market seems a lot more sustainable than in the 1920s or 30s. What could be responsible for this shift? I found an interesting post by a guy called Damien Klassen on a financial planner website that proposes adjustments for both corporate taxes and share buybacks. I liked the way he models the corporate tax adjustments and I will use his methodology one-for-one. But I will use a slightly different approach for the buybacks, more on that below.

Accounting for the lower corporate tax rate

First, why do we want to adjust for corporate taxes? Imagine there’s a corporation that generated (CPI-adjusted) pre-tax earnings of exactly $100 a year for the last 10 years. During the last five years, corporate taxes were 21%, and thus the corporation earned $79 after-tax. The five years before that, corporate taxes were 35% and the company earned $65. Your average 10-year rolling earnings were $72. But $72 is a really poor estimate for the earnings trend. Your tax rate today isn’t 28% but 21%. Thus, the Klassen adjustment takes all past earnings and divides them by 1.0 minus the then-prevailing tax rate to get a sense of the pre-tax earnings. And then you apply the current corporate tax rate to all past earnings. Klassen thus calculates the 10-year after-tax rolling earnings per share (EPS) as if today’s corporate tax rates had been in effect for the entire past 10 years. The reason for this adjustment is that it would take an entire 10 years for a tax cut like the 2018 corporate tax reduction (from 35% to 21%) to work itself through Shiller’s CAPE calculations. The Klassen adjustment applies the tax impact instantaneously, exactly when the tax cut happens.

CAPE: old and new since 1925.

And here’s a time series chart since 1970, when the adjustments are really the most noticeable. Instead of plotting the CAPE, though, I transform this into an earnings yield (one divided by the CAPE), so this would be a series with a positive correlation with future earnings.

https://drive.google.com/file/d/1ugtRN3TaAVwQi-20mjt4DctF-glppSMD/view?usp=sharing

Please let me know if you have trouble accessing the file. As usual, you can view the file, but before you do edits, you’ll have to download it to your own computer and/or Google Drive. I will run this (almost) every weekday, so you should be able to get regular updates on the most recent CAPE estimates, both the standard CAPE.ERN.1 and the adjusted CAPE.ERN.2. And for fun, you can also monitor how hopelessly outdated the Shiller numbers are. 🙂

Conclusion

Time to wrap up since we’re already pushing past 3,000 words. To sum up, we can easily fix Shiller’s data reporting lags and we can certainly apply some adjustments to the Shiller CAPE. But the measure remains solidly above its long-term average, even after the major drop this year. What does this all mean for retirees? Initially, I had planned to make this part 54 of my Safe Withdrawal Rate Series with additional calculations on how the different CAPE Ratio scenarios impact your retirement safe withdrawal rates, but I will defer that to another post, hopefully in the next one or two weeks. Stay tuned!

I’m glad you stopped by today! Looking forward to your comments and suggestions below!

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