The CAPE ratio, or Cyclically Adjusted Price-to-Earnings ratio, is a valuation measure used in finance and economics to assess whether a stock market is overvalued or undervalued. It is also known as the Shiller P/E ratio, named after economist Robert Shiller who popularized its use. The CAPE ratio is different from the traditional Price-to-Earnings (P/E) ratio in that it takes into account the inflation-adjusted average earnings over a specific period, typically the past 10 years.

Here’s how the CAPE ratio is calculated:

1. **Average Earnings Calculation:**
– Calculate the average of the real (inflation-adjusted) earnings of a market index (e.g., the S&P 500) over the past 10 years.

2. **Current Market Price:**
– Determine the current market price of the index.

3. **Calculate CAPE Ratio:**
– Divide the current market price by the average real earnings calculated in step 1.

The formula is expressed as follows:
\[ \text{CAPE Ratio} = \frac{\text{Current Market Price}}{\text{Average Real Earnings Over 10 Years}} \]

A higher CAPE ratio suggests that the market may be overvalued, while a lower ratio may indicate undervaluation. The CAPE ratio is often used to assess the potential for long-term returns in the stock market.

Key points about the CAPE ratio:

– **Mean Reversion:** Proponents of the CAPE ratio argue that, over the long term, stock market valuations tend to revert to their historical mean. Therefore, a high CAPE ratio may signal lower future returns, and a low CAPE ratio may suggest higher future returns.

– **Criticisms:** Critics of the CAPE ratio point out limitations, such as changes in accounting standards over time and variations in economic conditions. Additionally, the CAPE ratio has been historically high in periods of low-interest rates, which may influence its interpretation.

– **Global Application:** The CAPE ratio can be applied not only to individual stock markets but also to assess the valuation of entire countries’ stock markets.

It’s important to note that while the CAPE ratio can provide insights into market valuations, it is not a perfect predictor of short-term market movements, and other factors should be considered in investment decision-making. Investors and analysts often use a combination of valuation metrics and economic indicators for a more comprehensive assessment of market conditions.