The cyclically adjusted price-to–cash earnings ratio (CAPCE) is an equity valuation tool that helps investors understand the cheapness or expensiveness of a market. The ratio compares an equity index price level to the average real cash earnings generated by the companies of that index across the trailing ten-year period. While every valuation metric including CAPCE has limitations, elevated CAPCE ratios have historically been associated with sub-par subsequent returns and vice-versa.

The CAPCE’s helpfulness as a valuation tool stems from its construction. First, using cash earnings provides a good estimate of cash flows available to equity owners of non-financial businesses, given that it adds back non-cash depreciation and amortization charges to earnings. Second, averaging inflation-adjusted cash earnings over a trailing ten-year period provides a better indication of a market’s true earnings power, as opposed to volatile one-year levels. These two aspects of its construction promote a stable fundamental measure of value against which price changes can be compared.

Still, we believe that the use of superior valuation ratios is necessary but not sufficient to make successful investment decisions. Investors can position themselves for better outcomes by holistically understanding both how markets have evolved over time and their current state, incorporating views on valuations, momentum, fundamentals, and the macro-economic environment. Investors should consider the CAPCE ratio as a tool to help assist with investment decision-making processes.