Sunday 21 April 2013

The New S&P 500 Cyclically Adjusted Price Earnings Ratio (S&P500 CAPE) Update - April 2013

I've been publishing a review of the S&P500 and all its nuances every month for over 3 years.  This is data that I personally use for my own investments and as my knowledge has grown so too has the content posted but the format has remained largely unchanged.  I've received no complaints but to me the format has now grown a little unwieldy, not as clear as it could be and probably most importantly I've become a little bored with it.  Last month’s review can be found here.  I've therefore spent some time reformatting the charts, adding some more relevant historical content and hopefully arranging the content into something a little more logical.  I hope it works for you.

S&P500 Price

At market close on Friday the S&P500 was Priced at 1,555.  That is a rise of 0.3% when compared with 1,551, which is the average closing Price of each trading day last month.  It is 12.2% above last year’s April monthly Price of 1,386.  Note that for this index I only look at monthly average Prices as opposed to hourly or daily as I'm a very long term investor and just don’t need the noise associated with more granularity.  I’ll leave that for the traders out there.

We can then look at how this Price compares to history which is shown in the chart below.

Chart of the Monthly S&P500 Price
Click to enlarge

This is a similar chart to that which you will see in many places within the mainstream media when displayed over a long term.  It looks sensational and in my opinion isn’t very helpful.  Let’s therefore adjust it to the chart below where I try to show what is really going on with Prices.  I make two adjustments:

  • Correct the chart for the devaluation of the US Dollar through inflation.  This unfortunately means, unlike the mainstream media in recent times, I can’t report that the S&P500 has reached new all time highs as in real terms it is still 22.5% below the Real high reached in August 2000.
  • Show the Pricing on a logarithmic scale as opposed to a linear one.  By using this scale percentage changes in price appear the same.  For example let’s say we have two historic prices of 10 and 100.  If they both increase in price by 10% then they increase by 1 and 10 respectively.  On a linear scale it would appear as though the second has increased by a factor of 10 more than the first where on a logarithmic scale they will appear to have changes the same.  Less sensational but more correct. 

Chart of the Monthly Real S&P500 Price
Click to enlarge

S&P500 Earnings

As Reported Nominal Annual Earnings (using a combination of actual and estimated earnings) are currently $90.10.  That compares with this time last year at $88.33 implying earnings growth of 2.0% year on year.  Or course this looks better than it really is as inflation flatters the result.  I therefore plot a chart below, again on a logarithmic axis, showing Real (inflation adjusted) Earnings performance over the long term.

Chart of Real S&P500 Earnings
Click to enlarge

This only tells half of the Earnings story as it is an absolute number and so doesn’t help us with assessing market value.  Let’s therefore divide the nominal Earnings by the nominal Price to calculate the Earnings Yield.  Today that’s 5.8% and can be compared with history in the chart below.

Chart of S&P500 Earnings Yield
Click to enlarge

S&P500 Dividends

Dividends matter.  Today annual dividends for the S&P500 are at $32.11.  The Real inflation adjusted growth of S&P500 Dividends, which is what many long term buy and holders including myself are looking for, can be seen in the chart below.

Chart of Real S&P500 Dividends
Click to enlarge

If we divide Dividends by Price we get the Dividend Yield which is currently a lowly 2.1% and can be compared with history below.

Chart of Real S&P500 Dividends
Click to enlarge

Valuing the S&P500 – The Price/Earnings Ratio (P/E or PE) and the Cyclically Adjusted Price/Earnings Ratio (aka Shiller PE, PE10 or CAPE)

Many people use the S&P500 P/E as a valuation metric.  It’s actually nothing more than the inverse of the Earnings Yield shown above.  Today it sits at 17.3 which is down on last month’s 17.5.

Personally I prefer to use the S&P500 CAPE.  It was made famous by Professor Robert Shiller and is the ratio of Real (ie after inflation) S&P 500 Monthly Prices to 10 Year Real (ie after inflation) Average Earnings.  It is also important to highlight that my calculation method varies from that of Professor Shiller.  He only uses S&P 500 Actual Earnings data where because I use the S&P 500 CAPE to make investment decisions from I also include extrapolated Earnings estimates right up to the present day.  This is to try and make the valuation as current as possible.

So what is the CAPE trying to achieve?  We know that we live in a society where boom and bust prevails and the CAPE is simply trying to smooth out the boom and busts to help identify when value is with us.  Today the S&P500 CAPE sits at 22.3 which is down on last month’s 22.4.

Both valuation metrics are shown in the chart below.

Chart of the S&P500 Cyclically Adjusted PE and S&P500 PE
Click to enlarge

Does it work?  Well only time will tell but what I can say is that history suggests it has some value.  If we look at a history of 5 Year Nominal Total Return (Capital Gain + Dividends) of the S&P500 and compare that with the two valuation metrics we find:

  • The P/E has a correlation of -0.32 which is considered a weak or low correlation.
  • The CAPE has a correlation of -0.46 which is considered a moderate correlation.  So it’s not perfect but it’s better than P/E when looking over longish periods which suits an investor like me.

A chart showing this CAPE to 5 Year Total Return is shown below.  With the CAPE at 22.3 the trendline implies a person buying today could expect a future Nominal 5 Year Total Return of around 34%.

Chart of the S&P500 CAPE versus the 5 Year Total S&P500 Return
Click to enlarge

Some other CAPE metrics that may be of interest:

  • The correlation between the Nominal S&P500 Price and the S&P 500 PE10 from present day back to 1881 is 0.66.  That is also considered moderate and is another reason I use this metric to make investment decisions from.
  • The Dataset Average S&P 500 PE10 which dates back to 1881 is 16.5.  Assuming this is “fair value” it indicates that the S&P500 is some 35% overvalued.
  • The Dataset Median S&P PE10 is 15.9.
  • The Dataset 20th Percentile S&P 500 PE10 is 11.1.
  • The Dataset 80th Percentile S&P 500 PE10 is 20.9.

Making Personal Investment Decisions from this Data

My Retirement Investing Today Strategy drives tactical allocations from CAPE values.  It uses the S&P500 CAPE to set my allocation to the International Equities portion of my portfolio.  This is strategically set at 15% of total assets and is targeted to consist of 40% US Equities, 40% Europe Equities and 20% Japan Equities.  I then add the S&P500 CAPE tactical spin on top of this with a target of 10.5% allocation should the PE10 climb to 26.5 (Average PE10+10) or 19.5% should the PE10 fall to 6.5 (Average PE10-10).  Therefore today my tactical allocation sets itself below 15% at 12.4%.

As always do your own research.

Assumptions include:

  • S&P500 Prices are month averages except April 2013 which is the 19 April 2013 market close Price.
  • April 2013 Dividend is assumed to be equal to the March 2013 Dividend 
  • January to April 2013 As Reported Earnings are estimates from Standard & Poor’s.  
  • Inflation data from the Bureau of Labor Statistics.  April 2013 inflation is extrapolated.
  • Historic data provided from Professor Shiller website.


  1. "We know that we live in a society where boom and bust prevails": that's not what Gordon Brown said.

    1. Hello RIT,

      I know this is rather random, but my portfolio is growing signifcantly and i'm a little nervous. I'm with H & L (SIPP & ISAs).

      I would really like to hear your views on dividing your assets among several brokers, is that something you do or recommend to guard against brokers failing, or am i being a little paranoid ?


    2. Hi dearieme

      Great minds think alike. I actually had that mentioned in the original post but took it out as part of my usual need to make a post that is way too long at least tolerable in length for most readers.


    3. Hi Anonymous

      I obviously can't provide finacial advice as I'm not one of those type of people but I can tell you what I do.

      Even though each broker should have your funds ring-fenced meaning your assets are protected in the event of the broker going bankrupt there could always be a fraudulent or similar event. I therefore do try and spread it around amongst brokers where possible. It's a fine balance between minimising costs, simplifying management and minimising risk.

      The majority of my funds are spread as follows:
      - Trading Account with Hargreaves Lansdown
      - ISA with TD Direct
      - SIPP with SippDeal
      - Company Pension. An insurance company who I won't mention as I wouldn't recommend them.
      - Index Linked Savings Certificates with NS&I
      - Cash with a UK Bank (who I won't recommend)
      - Cash with an Offshore Bank
      - A couple of other funds held directly. This is mostly legacy stuff where selling would expose me to gains that would generate undesired taxes that I'm not ready to crystalise during my "peak earninsg period".

      Any other readers care to give their view point on the question?


    4. I've often wondered / worried about this issue. I have a couple of share ISAs, each time I get to an uncomfortably large balance I stop contributing and start again with a different broker. Other investments are also scattered.

      With cash investments it is simple to know when to split the investment; £85k. But what is a sensible threshold for funds to hold in a single shares ISA? Plus there is a complication that shares tend to increase in value over time but are harder to move between accounts, so when setting a threshold for funds to hold in a single account one should leave a little headroom for growth.

      So the question is, what is a sensible threshold for funds to hold in a single shares ISA? Any views?

  2. We have our S&S ISAs spread over four suppliers, our Cash ISAs over half a dozen, our personal pensions with three more. We use ns&i too. We have a few hundred quid in a foreign bank account which I must get round to bringing home and "investing" in the garden. Our dwindling non-tax-sheltered cash is in two of those current accounts that pay interest - a different company again - and a regular savings account that will finish in the autumn. One problem; our occupational pensions come from the same scheme. One answer; I drew the largest permitted lump sum. We are not diversified in property: we have one house and we have no plans ever to own two.

    It's not that any of these investments are pressing against the guarantee thresholds, it's just that I'd need a very compelling reason to concentrate them rather than leave them scattered - some tiny reduction in costs wouldn't persuade me.

  3. Goodness, that's paranoia! We have all ISAs and sipps in H and L, and cash in NSI. The risk is in the funds we hold, not the broker. Having everything in one place makes management trivial.

  4. I've been thinking about this also. Would love a dedicated post on the topic RIT! (I'm sure you have nothing else to do ;-)).

    Yes - theoretically any fund/share holdings are required by the FSA to be held in a nominee account of the broker and that this nominee account be separate from the assets of the company so no creditors should have a claim on it in the case of the broker going bust.

    Shares/funds are protected up to £50k by the government scheme if the worse were to happen. This seems pathetically low to me - I believe clients are protected upto $250k in America by their insurance scheme.

    Unfortunately I started putting in this years contribution before I investigated this and am going to exceed the limit (unless there is a stock market crash, which is not too improbable).

    It would be a right hassle to manage my shares across various brokers. Less hassle than losing my life-savings I suppose. I think next year I will open a second account to spread things a little.

    I think its (hopefully) unlikely that the combination of - 1) the broker goes bust + 2) they were fraudulent/incompetent + 3) their auditors were fraudulent/incompetent + 3) the FSA identified no compliance issues - would occur.

    1. Hi Gravitas

      On occasion I do take requests for posts but this one is a little wide of my core skill set :-) I am however going to do some reading on it as it is an important topic so I may end up with a few words on it.

      I'm with you on the risk though. I diversify where sensible, don't lose too much sleep over it and agree there must be a number of serious failings in series for the risk to come to fruition. That said over the past few years we've definitely seen plenty of busts, fraud, incompetent/reprehensible auditing and an FSA asleep at the wheel so I'd say it is possible. It's just that I'm spending more time watching bank account FSCS limits as they are IMHO likely to blow up and also ensuring I don't accidently buy any synthetic investments that will turn to dust in the event of the wrong bankruptcy.