The CAPE (Cyclically Adjusted P/E) Ratio Fallacy

Also known as the P/E 10 Ratio, this valuation measure was eventually discarded by its originator — Benjamin Graham — who was also Warren Buffett's mentor.

Definition

The CAPE ratio is a valuation measure that is used to assess whether the market is undervalued or overvalued. The ratio uses earnings per share (EPS) over 10-year periods, and is based on Graham's 1934 book Security Analysis.

Dismissal

But in his 1973 edition of The Intelligent Investor, Graham writes that the ratio was no longer reliable after 1949.

“In 1949 we could present a study of stock-market fluctuations over the preceding 75 years, which supported a formula— based on earnings and current interest rates—for determining a level to buy the DJIA below its “central” or “intrinsic” value, and to sell out above such value. It was an application of the governing maxim of the Rothschilds: “Buy cheap and sell dear.”* And it had the advantage of running directly counter to the ingrained and pernicious maxim of Wall Street that stocks should be bought because they have gone up and sold because they have gone down. Alas, after 1949 this formula no longer worked.”

Explanation

In a later chapter, Graham also explains the possible reason why the ratio ceased to work: the fact that its usage became commonplace.

"In both cases the advent of popularity marked almost the exact moment when the system ceased to work well. We have had a like discomfiting experience with our own “central value method” of determining indicated buying and selling levels of the Dow Jones Industrial Average. The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last. Spinoza’s concluding remark applies to Wall Street as well as to philosophy: “All things excellent are as difficult as they are rare.”"