CAPETracker.com

CAPE Stocks

CAPE Stocks refer to stocks or equities that are evaluated based on the Cyclically Adjusted Price-to-Earnings (CAPE) ratio. These are typically selected or screened using the CAPE ratio to assess whether their valuations are attractive relative to historical earnings, adjusted for inflation. The CAPE ratio helps smooth out short-term earnings volatility and provides a more long-term perspective on a company’s or stock’s valuation.

Understanding CAPE Stocks:

  1. The CAPE Ratio for Individual Stocks: The CAPE ratio is calculated for individual stocks by taking the current price of the stock and dividing it by the average inflation-adjusted earnings over the past 10 years. This measure is useful for investors looking for companies with:
    • Attractive Valuations: A low CAPE ratio could indicate that a stock is undervalued, presenting a potential opportunity for long-term growth.
    • Less Cyclical Earnings Volatility: Since the earnings are averaged over a decade, the ratio helps minimize the impact of short-term market fluctuations or economic cycles.
  2. High vs. Low CAPE Stocks:
    • High CAPE Stocks: A high CAPE ratio suggests that a stock is expensive relative to its earnings over the past decade. This could signal overvaluation, meaning investors might expect lower future returns or a price correction. High CAPE stocks often belong to growth companies with strong market positions but may be at greater risk if the market turns bearish.
    • Low CAPE Stocks: A low CAPE ratio indicates that a stock is relatively cheap compared to its historical earnings, suggesting that it might be undervalued. Low CAPE stocks are often considered value investments, which could lead to higher future returns if the market corrects or revalues these companies.
  3. CAPE Stock Screening: Investors or fund managers may use the CAPE ratio to screen for stocks that are undervalued (low CAPE) or overvalued (high CAPE). By focusing on low CAPE stocks, they can potentially capture value opportunities where the market has overlooked or undervalued a company’s earning potential.
    • Value Investing: Many value investors look for low CAPE stocks, as they may be undervalued relative to historical earnings and could have significant growth potential when the market re-evaluates their true worth.
    • Growth Investing: Some growth investors might avoid stocks with low CAPE ratios, believing that these companies may not have strong growth potential. Conversely, high CAPE ratios might attract growth investors who expect future earnings to justify the current price.
  4. Sector and Market Impact: The CAPE ratio can vary widely between different sectors and markets. For example:
    • Technology Stocks: Often have higher CAPE ratios because investors are willing to pay a premium for expected future growth.
    • Utility Stocks: Tend to have lower CAPE ratios because they are more stable and have less room for rapid growth.
    Some sectors, such as financials, consumer goods, or industrial stocks, may have CAPE ratios that are relatively in line with the broader market, while others, like growth-focused technology stocks, might have significantly higher CAPE ratios.
  5. Why CAPE Stocks Matter:
    • Market Cycles: The CAPE ratio helps investors navigate market cycles by highlighting periods of overvaluation or undervaluation, based on long-term trends. For example, during times of economic expansion, the CAPE ratio might rise as stock prices increase, signaling possible overvaluation. Conversely, during downturns or corrections, a low CAPE ratio might suggest undervaluation and potential buying opportunities.
    • Predicting Long-Term Returns: Historical research by Robert Shiller and others has shown that markets with high CAPE ratios tend to experience lower long-term returns, while markets with low CAPE ratios offer higher potential returns. By focusing on stocks with attractive CAPE ratios, investors may align their portfolios with long-term growth opportunities.
  6. CAPE Stock Investment Strategies:
    • CAPE-Based Indexing: Some investment strategies and ETFs track low-CAPE stocks or indices. For example, a low-CAPE index might exclude high-CAPE stocks in favor of those that are undervalued.
    • CAPE as a Signal for Timing: While the CAPE ratio itself is not a precise short-term predictor, it can offer valuable signals about the relative valuation of stocks in the long run. For example, when the broader market’s CAPE is high, investors might consider reducing exposure to riskier assets.

Pros and Cons of Using CAPE for Stocks:

Pros:

  • Long-Term Perspective: The CAPE ratio is helpful for long-term investors, as it smooths out economic cycles and provides a clearer picture of how a stock’s price relates to historical earnings.
  • Valuation Tool: It can be an effective tool for identifying undervalued or overvalued stocks, offering insights into future return potential.

Cons:

  • Ignores Short-Term Factors: The CAPE ratio does not account for short-term events, such as sudden changes in a company’s earnings or shifts in market sentiment.
  • Economic or Sector-Specific Changes: Changes in market conditions, industry dynamics, or accounting standards can distort the usefulness of CAPE ratios, particularly in sectors where earnings growth rates may change significantly over time.
  • Not Always Predictive: Although CAPE ratios correlate with long-term returns, they are not a foolproof measure of stock price direction in the short term.

Conclusion:

CAPE stocks represent a subset of equities analyzed through the Cyclically Adjusted Price-to-Earnings ratio. Investors use this ratio to assess whether stocks are overvalued or undervalued, often as part of a value investing strategy. While the CAPE ratio is an effective tool for evaluating long-term potential and market cycles, it is important to consider it alongside other metrics and broader market conditions when making investment decisions.