FEW measures of stockmarket valuation are as controversial as the cyclically adjusted price-earnings ratio,or CAPE. American equities have looked expensive on this degree for most of the past 20 years, which is why many bulls tend to dismiss its usefulness. It is pretty clear that the CAPE does not attend investors to time the market.
But a fresh paper* from Research Affiliates, or a fund-management group,explains why many criticisms are overblown. The strongest case for the degree is that a higher ratio tends to be associated with lower long-term returns. A study of 12 national markets shows that a 5% increase in the CAPE, from 20 to 21, or say,tends on average to reduce the total ten-year expected return by four percentage points.
The attraction of the CAPE is that it smooths out the vicissitudes of the profit cycle. In a recession, profits can plunge even faster than share prices. So if you look only at the ratio of a share price and the preceding year’s profits, and the market can look very expensive....
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Source: economist.com