I've had this idea in the past that the CAPE ratio does a poor job of capturing very material, structural changes to earnings.
One example is the effect that the ***Tax Cuts & Jobs Act in 2018*** had on earnings. That resulted in a very discrete change in earnings as a portion of taxes effectively flowed to the bottom line over night. This is something that isn't captured in something like the Shiller PE that has a 10-year lookback. So stocks look more expensive than they actually are.
Just a quick background on the CAPE ratio. ***CAPE takes today's price and divides it by the average of the trailing ten years of inflation adjusted earnings.***
I think I can make a compelling case that ***liquidity (not inflation) may actually be a better metric to adjust by***.
I wrote an [**entire article explaining why**](https://riskpremium.substack.com/p/fixing-cape-does-liquidity-matter), but the basic gist is that liquidity tells us how much money is floating around in the economic system that's available to be hoovered up by corporations. Put more money in the system, and we should expect a reciprocal increase in earnings. We can't really say the same for the price index.
Put another way, *Joe's* level of spending is tied more to how much money *Joe* has rather than the cost of goods that *Joe* buys.
If you follow the link, I have charts showing that nominal earnings have a better correlation with liquidity rather than inflation.
Making this adjustment, I think we're better able to capture the effects of the liquidity spike that occurred in 2020 during Covid. More money, more earnings as they say.
***Because of this, stocks may have actually been relatively cheap in 2021 thru 2023.*** Or at least the valuations at the time might have been overstated. I can even make the case that adjusted-CAPE was <25x when the reading was near 40x in 2021 (which I know sounds silly).
***Unfortunately, looking at today, stocks are expensive no matter which way you slice it.*** Even with this new adjustment, I think we can maybe only say that the "true" cyclically adjusted ratio is 37x instead of 40x. If the market *is* cheap, I haven’t found a reason yet.