Cyclically adjusted price-to-earnings ratio

The cyclically adjusted price-to-earnings ratio, commonly known as CAPE or Shiller P/E, is a valuation measure usually applied to broad equity markets. It is defined as price divided by the average of ten years of earnings, adjusted for inflation.

Graham and Dodd noted one-year earnings were too volatile to offer a good idea of a firm's true earning power. Decades later, Yale economist Robert Shiller popularized the 10-year version of Graham and Dodd's P/E as a way to value the stock market.

Mebane Faber extended Shiller's work to include over thirty foreign markets around the globe in his paper Global Value: Building Trading Models with the 10 Year CAPE

Over seventy years ago Ben Jamin Graham and David Dodd proposed valuing securities with earnings smoothed across multiple years. Robert Shiller popularized this method with his version of this cyclically adjusted price-to-earnings ratio (CAPE) in the late 1990s, and issued a timely warning of poor stock returns to follow in the coming years.  We apply this valuation metric across over thirty foreign markets and find it both practical and useful, and indeed witness even greater examples of bubbles and busts abroad than in the United States.  We then create a trading system to build global stock portfolios based on valuation, and find significant outperformance by selecting markets based on relative and absolute valuation.

Summary chart from the paper:

- See more at: http://www.mebanefaber.com/2012/08/23/global-value-building-trading-models-with-the-10-year-cape/#sthash.Qk1lE2eG.dpuf