The CAPE (Cyclically Adjusted P/E) Ratio Fallacy

Content

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.”

Benjamin Graham, Chapter 1: Investment versus Speculation, The Intelligent Investor

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.”"

Benjamin Graham, Chapter 8: The Investor and Market Fluctuations, The Intelligent Investor

However, Graham did give detailed instructions on how his stock selection framework could be adapted to changing interest rates.

In the 2018 Balance of Power interview for Bloomberg Markets, Warren Buffett says yet again:

"The principles [of investing] haven't changed at all... It's exactly what Ben Graham wrote in 1949."

Warren Buffett, Bloomberg Markets: Balance of Power (2018).

Link
https://www.grahamvalue.com/blog/cape-cyclically-adjusted-pe-ratio-fallacy
Summary
The CAPE ratio, also known as the P/E 10 Ratio, is a valuation measure developed by Benjamin Graham to evaluate market conditions over a 10-year earnings period. Despite its initial utility, Graham later dismissed the ratio in his 1973 edition of 'The Intelligent Investor,' stating it became unreliable after 1949. He noted that the formula, which helped determine buying and selling levels for the Dow Jones Industrial Average, lost its effectiveness as it gained popularity among investors. Graham suggested that widely adopted strategies tend to become too simplistic and ineffective over time. He emphasized the importance of adapting investment strategies to changing market conditions, particularly interest rates. Warren Buffett, Graham's protégé, reiterated in a 2018 interview that the core principles of investing remain unchanged since Graham's time, highlighting the enduring relevance of Graham's investment philosophy. Overall, while the CAPE ratio was a significant tool in its time, its decline in reliability serves as a cautionary tale about the impact of popularity on investment strategies.