Mar 3, 2025 | 6 min read
Source: Bloomberg, Robert Shiller
Top Line Summary
Traditional CAPE remains a useful long-term valuation tool, but it has limitations. It relies on past index constituents, potentially understating today’s market valuations.
Current Constituents CAPE (CC CAPE) offers an alternative by focusing on today’s S&P 500 members. This adjustment may provide a more accurate real-time valuation measure, though its predictive power is still debated.
Markets are expensive, but AI-driven enthusiasm hasn’t reached dot-com bubble levels. The CAPE Spread—measuring the gap between CC CAPE and Shiller CAPE—is elevated, signaling heightened optimism but not outright euphoria.
Revisiting Market Valuations: Does the CAPE Ratio Need a Refresh?
Is It Time to Rethink How We Measure Stock Market Valuations?
Few valuation measures have stood the test of time like the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, developed by Robert Shiller. By smoothing earnings over a decade, CAPE helps cut through short-term market noise, offering investors a way to gauge whether stocks are cheap or expensive relative to history.
But CAPE is not without its critics. Some argue that it understates modern valuations, failing to account for structural changes in accounting rules, interest rates, and corporate earnings power. Others point to its backward-looking nature, as it incorporates the earnings history of companies that may no longer be relevant to today’s market.
Now, Research Affiliates has proposed a new take on CAPE, one that focuses on the current makeup of the market rather than its historical constituents. They call it Current Constituents CAPE (CC CAPE)—a tweak that they argue may offer better predictive power, particularly over shorter time horizons.
Does this mean traditional CAPE is outdated? Not necessarily. CAPE has historically been a useful, albeit imperfect, valuation tool. The real question is whether investors should rely on it as much as they have in the past, or whether it’s time to complement it with other approaches.
A Flaw in the Classic CAPE? Or Just Another Imperfect Indicator?
The core critique of traditional CAPE is that it calculates valuations based on past index members. Because stock indices like the S&P 500 routinely add high-flying growth stocks while removing underperformers, this means:
Recently dropped stocks (often cheaper ones) still influence CAPE’s denominator, potentially making valuations appear lower than they are today.
Recently added stocks (often expensive, high-growth names) have limited historical earnings in the calculation, which can also make the market seem cheaper than it actually is.
Research Affiliates argues that this results in a systematic downward bias—essentially making stocks appear less expensive than they really are. Their solution? Instead of relying on the earnings of companies that have come and gone, CC CAPE calculates CAPE only for stocks currently in the index.
This small but notable change could make CAPE a more responsive valuation tool, better reflecting the composition of today’s market.
That said, investors should be mindful of not overcomplicating things with new valuation metrics unless they provide a clear improvement over existing ones. As Acadian Asset Management points out, many alternative valuation measures—like household equity share and the so-called "Buffett Indicator"—are more misleading than useful. The challenge isn’t just finding new ways to measure valuation but ensuring that they actually add predictive value.
What Is CC CAPE Saying About Today’s Market?
The million-dollar question: What does CC CAPE tell us right now?
1. CC CAPE Confirms That Markets Are Expensive
Both CC CAPE and traditional CAPE are in their top historical deciles, suggesting that equities are richly valued. Research Affiliates notes that historically, when CC CAPE has reached similar levels, future 10-year annualized returns have averaged just 4.7%—a clear signal that investors should temper their long-term expectations.
2. The CAPE Spread Suggests AI Optimism, But Not a Bubble (Yet)
One of the more intriguing insights from the Research Affiliates paper is the spread between CC CAPE and Shiller CAPE. This difference—dubbed the CAPE Spread—measures how much higher CC CAPE is compared to traditional CAPE.
Historically, a wide CAPE Spread has been a signal of excessive market euphoria—most notably during the Dot-Com Bubble when CC CAPE soared far beyond Shiller CAPE due to the rapid addition of high-valuation tech stocks into the index.
Today, the CAPE Spread is elevated but not at 2000 levels. This suggests that while the current AI-driven market rally has pushed valuations higher, we are not yet seeing the same degree of irrational exuberance that marked past bubbles.
Exhibit 1: CAPE Comparison (Dec 1964 - Nov 2024)
Source: Research Affiliates, shillerdata.com
3. A Flashing Yellow Light for Medium-Term Risks?
Research Affiliates finds that the CAPE Spread has stronger predictive power for medium-term returns (3–5 years) than either CAPE measure alone. Historically, when the CAPE Spread is high, future stock returns tend to be lower over the following 3–5 years—a warning sign that the market may be more fragile than it appears.
Exhibit 2: Correlation of CAPE with Subsequent Returns (Dec 1964 - Nov 2024)
Source: Research Affiliates, S&P 500, shillerdata.com
This doesn’t necessarily mean a crash is imminent, but it does suggest that investors should be prepared for increased volatility in the coming years.
What This Means for Investors
Instead of treating any single valuation metric as a crystal ball, investors may be better served by thinking about them as pieces of a larger puzzle.
Here’s one way to integrate both CAPE and CC CAPE into a broader framework:
Use traditional CAPE to get a historical perspective – It’s time-tested and useful for identifying extremes in valuation cycles.
Compare it to CC CAPE for a more real-time snapshot – If CC CAPE is significantly higher than traditional CAPE, it may suggest that index changes have inflated valuations, making the market look cheaper than it actually is.
Watch the CAPE Spread – A widening spread could be a sign of increased market enthusiasm, which has historically preceded weaker medium-term returns.
Keep an eye on macro trends – Profit growth drives stock returns more than valuation levels. If corporate earnings remain strong, even a high CAPE may not be an immediate red flag.
The Bottom Line
CC CAPE is not about replacing Shiller CAPE—it’s about asking whether traditional valuation measures still capture today’s market reality.
Maybe CAPE’s flaws aren’t severe enough to warrant an overhaul. Maybe CC CAPE turns out to be a minor tweak rather than a breakthrough. Or maybe, as some argue, valuation metrics themselves may not be as useful as we assume.
At the very least, CC CAPE adds an extra lens to the valuation conversation—and in a market where valuations are already stretched, investors could use all the perspective they can get.
REFERENCES:
Current Constituents CAPE - Research Affiliates, accessed March 3, 2025 https://www.researchaffiliates.com/publications/articles/1070-current-constituents-cape
Mismeasuring the market: Valuation indicators to ignore - Acadian Asset Management, accessed March 3, 2025 https://www.acadian-asset.com/investment-insights/owenomics/mismeasuring-the-market
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