CAPE, Accounting and Long-Term Stock Returns: A Plain-English Pillar Guide

This pillar is a starting point for understanding CAPE, the accounting choices behind its earnings series and the debate over what long-run valuation measures can predict. It draws on a working paper that proposes CAPE-H, an adjusted alternative, while keeping the paper's claims separate from established accounting rules and general market facts.

Start with the ratio#

The Shiller CAPE ratio compares a broad stock index's price with the average of ten years of inflation-adjusted earnings. The long window smooths some short-term earnings volatility. It does not smooth away differences in accounting rules, changes in index composition or changes in the economy.

Use CAPE to frame a valuation question across long periods. Do not read it as a signal that a market correction is imminent. The ratio alone cannot explain why a market is expensive or predict the timing of a reversal.

Why the earnings measure matters#

Reported earnings reflect accounting conventions as well as business activity. The FASB's R&D standard generally requires research and development costs to be expensed when incurred. Palazzo's paper also studies special items, including charges that may make comparisons across years less direct.

The proposed CAPE-H adjusts for these categories. It is intended to improve historical comparability, not to claim that each R&D dollar is an asset or that every special item can safely be ignored. Readers should consider the measurement choices alongside the reported GAAP figures.

Guides in this pillar#

• What does the Shiller CAPE measure—and what can it miss?
• How R&D expensing and special items can change CAPE's earnings base
• CAPE-H explained: what the proposed accounting adjustments change
• Can CAPE forecast returns without timing a market crash?
• How share buybacks can change a CAPE comparison
• Why index weighting can change a CAPE forecast
• Why interest rates are only one part of a high CAPE
• Adjusted earnings: what to check before excluding special items
• Research paper proposes an accounting-adjusted way to read CAPE

Keep the forecast horizon in view#

Long-run valuation studies test whether starting valuations are associated with average outcomes over several years. John Cochrane's return-predictability research examines how valuation ratios relate to expected returns and dividend growth. Palazzo's paper reports that CAPE-H improves forecasts of price appreciation in parts of its sample.

Those results are statistical claims, not a schedule for the next decline. Different methods can produce different estimates, and rare tail outcomes are hard to forecast. A disciplined reading keeps the sample, horizon, earnings definition and uncertainty attached to every result.

The useful question is not only “Is CAPE high?” It is also “Which earnings series is being used, how comparable is it across time, what horizon is being forecast, and what can this evidence actually say?”