CAPE ratio explained: the long-run valuation test for a stock market crash

How is the CAPE ratio calculated, step by step?

Start with the price of a share index, usually the S&P 500. Take the earnings of each of the last 10 years and adjust each one for inflation, so that all 10 are expressed in today’s money. Average the 10 values. Divide the price by that average. The result is the cyclically adjusted price-to-earnings ratio, or CAPE.

An example with illustrative numbers shows the logic. An index at 4,000 with average real earnings of 200 over 10 years has a CAPE of 20. If the index doubles while the average earnings stay the same, the CAPE doubles to 40. The ratio rises when prices outrun the earnings that support them, which is the situation that precedes many sharp falls.

Why does the CAPE ratio use 10 years of inflation-adjusted earnings?

Company earnings swing with the business cycle. One strong year makes an ordinary price look cheap, and one weak year makes it look expensive. A 10-year window covers at least one full cycle, so booms and slumps offset each other. Campbell and Shiller concluded in 1988 that a long moving average of real earnings helps to forecast future real dividends.

The inflation adjustment puts old and new earnings on the same scale. Without it, the earnings of 10 years ago look small in current money, and the ratio would be inflated for no reason. The adjustment keeps the comparison honest across decades, which is what allows a reading from 1920 to sit beside a reading from 1999.

What does a CAPE value mean as an earnings yield?

Turn the ratio upside down and you obtain the earnings yield, the share of price that long-run earnings represent each year. A CAPE of 15.21, the 20th-century average, equals a yield of about 6.6%, which matches the average annual return of around 6.6% over the following 20 years that Wikipedia reports.

The same arithmetic gives a CAPE of 25 an earnings yield of 4%, and the series maximum of 44.19 in December 1999 an earnings yield of about 2.3%. A buyer at the 1999 peak purchased about a third of the earnings yield that the 20th-century average offered. This is why a high CAPE lowers the return that investors can expect.

Which CAPE levels count as expensive for stock market crash risk?

The long series on multpl.com shows a mean of 17.44 and a median of 16.13, with a minimum of 4.78 in December 1920. Readings well above these values describe an expensive market. In 2014 Shiller noted that a CAPE above 25 had been surpassed since 1881 in only 3 earlier periods, around 1929, 1999, and 2007.

Treat the levels as zones rather than triggers. Below the median, valuation supports the market. Between the median and 25, the market is priced above its history. Above 25, a large part of prices rests on expectations, and the cushion against a loss of confidence is thin. The guide on 1929, 2000, and 2008 shows each zone in action.

How accurate is the CAPE ratio at forecasting 10-year stock returns?

A 2020 article tested CAPE projections against actual outcomes. In 95% of 10-year periods, actual returns landed within 2.74% of the projection. In 67% of periods, they landed within 1.37%. These figures support the use of CAPE as a guide to long-run returns, and the guide covers horizons of 10 to 20 years.

The same record carries a warning. Wikipedia states that the ratio was never intended to predict crashes or low-points, and that it is not always accurate in signaling market tops or bottoms. Accuracy over 10 years and silence on timing sit together, so the test sizes risk and leaves the date to other signals.

Which mistakes distort a CAPE reading in a stock market crash review?

The first mistake is using CAPE as a timer. A high ratio has persisted for years, so a sale based on the ratio alone can come long before a fall. The second is ignoring rates: the ratio omits risk-free yields, so a high CAPE can coexist with low bond yields. The third is mixing definitions, since the choice of index changes the value.

A fourth mistake concerns earnings. Jeremy Siegel argued that accounting changes of the 1990s understate earnings, which raises the ratio. A reader who compares the 1999 value with the 1920 value should keep this point in mind. Stating the source, the index, and the date of each reading prevents most of these errors.

How do you apply the CAPE ratio test to crash risk in practice?

Write down the current CAPE from a named source, convert it to an earnings yield, and place it among the zones above. Repeat each quarter. Note the direction as well as the level, because a rising ratio with a flat economy adds to the cushion problem. This page is general information, not investment advice.

A 30-minute pre-diagnostic with EQOS Asia adds the structural view that valuation cannot give, and the EQOS Asia method page explains how the φ(S) score reads leverage, transparency, and integrity. Teams in Singapore, ASEAN, and Hong Kong combine both to size their exposure in calm periods.

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About the author

Stéphane Jambu

President, EQOS Forecast Asia

Stéphane Jambu leads EQOS Forecast Asia and works as a consultant in e-commerce, search visibility, and AI. LinkedIn profile