For those uninitiated in the arguments over long-term gauges of market valuations, the CAPE is a measure first promulgated by Benjamin Graham in the 1930s and popularized by Nobel laureate economist Robert Shiller 30 years ago. The idea is that earnings tend to follow a cycle, and that investors adjust for this when deciding what multiple to pay for a stock’s recent earnings. If at the bottom of the cycle, investors will tend to pay a higher multiple because they expect earnings to rise, and vice versa. The CAPE therefore compares prices to an average of earnings, adjusted for inflation, for the previous 10 years.
...This is how the CAPE has moved since 1880, as presented on Shiller’s website:
Shiller found fame for using the CAPE to help predict the dot-com crash of 2000 in his book “Irrational Exuberance.”
...the most popular critique by far was that the CAPE had been thrown off by the extraordinary earnings recession of a decade ago.
The extent of the earnings collapse during the crisis was extraordinary. Indeed, it was unprecedented. This next chart shows Shiller’s entire data set for corporate earnings going back to 1870. It is necessary to show it on a log scale; and the earnings recession of a decade ago looks even more like an utterly unpredictable Black Swan:
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