CAPE at ~40: what it is, what it isn’t, and what it should change (now)

CAPE (Shiller P/E) is the S&P 500 price divided by 10 years of inflation-adjusted earnings. The point is simple: a normal P/E can look “reasonable” right before earnings collapse (recessions), because the denominator is temporarily inflated. CAPE tries to smooth that cycle.

Right now, CAPE is sitting around ~40.

That’s not “a little expensive.” That’s rare air.

1) What CAPE is actually good for

CAPE is not a crystal ball for next quarter. It’s a risk-compensation meter.

Over long horizons (think a decade), valuation does most of the explaining. If you pay a high multiple on normalized earnings, you pull future returns into the present. You’re basically pre-spending your next decade.

So CAPE’s real function is:
“What’s the most realistic 10-year return I should expect starting from here?”

If that expected return is thin, you don’t need a crash call to behave differently. You just need arithmetic.

2) What CAPE is NOT

CAPE is not a timing signal.
Markets can stay expensive for years. A high CAPE can be followed by more gains. It can also be followed by flat returns. Or a drawdown. CAPE doesn’t tell you when.

What it does tell you is that the set of good outcomes gets narrower.

If the market is priced for perfection, your “probability-weighted decade” becomes a game of:

• “Will earnings growth stay great?” AND

• “Will margins stay high?” AND

• “Will rates behave?” AND

• “Will multiples stay elevated?” AND

• “Will nothing break?”

That’s not impossible. It’s just… a lot of simultaneous perfection.

3) The “20–30 CAPE” vs “40 CAPE” distinction

At CAPE 20–30, you can still plausibly grant the market a benefit of the doubt:

• index composition changes (more asset-light, higher-margin businesses),

• buybacks vs dividends,

• accounting shifts,

• globalization / winner-take-most dynamics,

• and sometimes “rates make higher multiples survivable for longer.”

You don’t love it, but you can still argue “this might be a pricey equilibrium.”

At CAPE ~40, the benefit-of-the-doubt argument starts sounding like:

“Everything stays structurally perfect for a decade.”

That’s like telling a runner they’ll comfortably run another full marathon while they’re visibly in distress.
Not a timing call. Just a recognition that the body is already under strain.

4) Why “but rates!” matters (and also doesn’t save you)

Any rational CAPE discussion has to acknowledge rates. High multiples can persist when real yields are low.

But “rates explain it” isn’t the same as “returns are attractive.”
Even if rates justify the level, they don’t magically restore forward return potential.

A practical way to think about it:

• CAPE gives you an estimate of the market’s normalized earnings yield (roughly 1 / CAPE),

• then you compare that to what you can earn risk-free (or inflation-protected),

• and you ask: “Is the extra compensation for equity risk actually generous?”

At CAPE ~40, the answer is usually “not generous.” It can still work. But it’s not a fat pitch.

5) The core risk CAPE captures (that people forget)

The biggest silent assumption embedded in “CAPE ~40 is fine” is profit margins.

If margins are structurally higher forever, CAPE can “look too high” historically.
If margins mean-revert even partially, then today’s earnings are less normal than they feel—and CAPE is actually being polite.

This is why CAPE tends to be most useful when you’re deciding how much optimism you’re willing to prepay.

6) What should change in behavior when CAPE is ~40?

Not “sell everything.” Not “short.” Not “panic.”

A rational long-term response is boring—and that’s the point:

1. Raise your required margin of safety.
   New money should demand better compensation than “hope the multiple stays this high.”

2. Size risk smaller.
   If expected decade returns are compressed, you don’t need huge exposure to meet your goals. You need survivability and optionality.

3. Prefer ballast and cash-flow durability.
   When the index is priced for perfection, you want assets that don’t require perfection to justify ownership.

4. Pre-commit to “what would change my mind.”
   Examples:

   • CAPE falls materially (price down, or earnings up sustainably),

   • risk-free yields fall while earnings stay resilient,

   • credit stress widens and then stabilizes (better entry compensation),

   • breadth improves for real (not just a few names dragging the index).

In other words: don’t argue with the market—just refuse to overpay for it.

7) The bottom line

CAPE ~40 doesn’t tell you a crash is coming.
It tells you the market is priced like the next decade will be unusually smooth and unusually profitable.

That’s not impossible.

It’s just a tough environment for new risk—because the math is already doing damage to forward returns.

The correct stance isn’t drama. It’s discipline:
cash as baseline, risk as earned, and entries only when compensation improves.