What Does Average Mean?

The cyclically-adjusted price-to-earnings (“CAPE”) ratio is normally credited to Nobel-prize winning economist Robert J. Shiller. It adjusts for the ups and downs of business cycles by comparing the price of the S&P Composite Index to the average, annual inflation-adjusted earnings of that index over the previous 10 years. There are three types of averages: mean, median and mode. The type of average the CAPE ratio uses is the mean (a.k.a. arithmetic mean). Though the CAPE ratio has been shown to be a reliable predictor of future long-term stock market returns, it has also been widely criticized.

One criticism is that the CAPE ratio is susceptible to outliers. For example, those abnormally weak earnings that occurred during the GFC drag the mean, annual inflation-adjusted earnings down. This could make the CAPE ratio of the S&P Composite Index look more expensive than it may actually be. It has been widely reported that the CAPE ratio is currently at a very high level behind only two other stock market peaks: 1) the Tech Bubble, and 2) the stock market bubble that occurred during the Roaring Twenties (immediately preceding the Great Depression). In both cases, the stock market eventually crashed and in spectacular fashion.

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