On Saturday, August 16, Robert Shiller released a short post to the New York Times where he reiterated the high level at which the CAPE for the S&P 500 stood currently, and then speculated on a few reasons why CAPE, or in his view the overall market, might be overvalued. Based on the high value of CAPE and other factors, it is difficult for most analysts to state that the U.S. Market is not overvalued as a colleague argues here at Seeking Alpha.
We can probably state with some level of accuracy, through our utilization of CAPE that the stock market is generally (in aggregate) overvalued. However can we also use CAPE to explore value in other ways? While the U.S. Market is quite possibly overvalued, it is also possible that our utilization of CAPE should lead us to other markets or other methods of investing instead of selling off and holding cash or in an even more drastic way, simply start shorting the S&P 500. While I have explored some of these methods here at Seeking Alpha and at my site in the past, I want to explore a more global approach to the utilization of CAPE within this article.
Brief Summary of the U.S. Market Situation With Respect To CAPE:
Let's first take a look at the key aspects of the Shiller article from last weekend. For those uninitiated with the CAPE Ratio as a measurement of market overvaluation, the theory runs as such - if CAPE is higher than the historic mean of roughly 15 - 16 then the market is overvalued. CAPE stands for Cyclically Adjusted P/E Ratio (we all know the P/E ratio right?) and you can read more about how it is calculated at my site right here. Shiller also provides his data set for the calculation of the ratio for the entire S&P 500 with data going back to 1871 right here. At Shiller's site you can also get the link to his book Irrational Exuberance, where he explains in much more depth why a high CAPE is an indicator of bad things to come for the overall market.
When the CAPE Ratio for the entire S&P 500 goes over the 15 - 16 range, then in theory the market is overvalued within the historical context. However the CAPE Ratio has, in more recent times, been higher than its historic mean over the last 100 years for quite a while as even Shiller states in the following:
The ratio has been a very imprecise timing indicator: It's been relatively high - above 20 - for almost all the last 20 years, with the exception of 20 months, mostly in the recession of 2007-9, when prices tumbled and it fell as low as 13.32.
As a result, when the CAPE Ratio went north of 20 more recently, few people became terribly concerned.
There are naturally a number of arguments for why the CAPE has been higher more recently, and naturally arguments pertaining to the reason why CAPE can remain high for long periods of time. I find all of these arguments quite interesting, but probably too much to discuss at length here. You can read the article linked to above by Shiller for some exploration of the topic and from the academic perspective. Or you can read from Joshua Brown at The Reformed Broker a slightly different and more practical perspective on the topic. To sum it all up, most arguments seem to state that with low interest rates and with an ever increasing number of institutional investors looking for a return on the dollar, it has become too difficult to find any other asset class besides equities that will provide an adequate return. As a result, people simply keep piling into the same overvalued heap. Shiller points out a few holes in this argument, but overall this seems to be the general consensus from most professionals discussing this topic.
In any case, the trouble now as Shiller points out, is that the CAPE is over 25.
I wrote with some concern about the high ratio in this space a little over a year ago, when it stood at around 23, far above its 20th-century average of 15.21. (CAPE stands for cyclically adjusted price-earnings.) Now it is above 25, a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.
And to help illustrate this issue here is a quick visual provided in part by multlp.com:
While it is easy for us to ignore a CAPE Ratio of 20, it may become increasingly difficult to ignore a CAPE Ratio value of higher then 25. You can also see a nice video clip of Shiller discussing this (with some customized charts provided by myself) right here at Fox Business News.
How do we invest now that we know the market is possibly overvalued?
The CAPE Ratio seems to show us that the United States equity market is overvalued. Can the CAPE Ratio point us towards an alternative investment strategy, one that does not simply imply that the S&P 500 should be shorted? I believe that it can, and I believe that this can be done in one of two ways.
A) Attempt to find individual pockets of value within the United States equity market, an approach which has been explored by only one other fund manager and which I outline only briefly here in an article on how to double the return of the S&P 500.
B) The other approach is based on an approach towards global value and is outlined in Meb Faber's more recent book (March 2014) which you can find right here. This will be the approach that I focus most of the remainder of this article on.
I suppose the third, or possibly the method that should be considered first, is the method utilized by Shiller and employed by Barclay's Capital in the ETF CAPE which essentially utilizes the CAPE by sector within the S&P 500 and attempts to invest more heavily within the areas identified as offering more value. A great deal has been written on this ETF and you can find one such paper from Barclay's right here. Shiller along with Oliver Bunn also put out a whitepaper on this topic back in June which you can find through this link here.
Looking to the Emerging Economies for Value:
There is an ETF which just recently launched at the start of March 2014 and which is managed by Cambria Funds under the name Cambria Global Value ETF with ticker symbol GVAL which focuses exclusively on investment in countries with low CAPE values.
How does GVAL do this? Cambria Funds explains this in a nutshell as follows:
The Index begins with a universe of 45 countries located in developed and emerging markets... The Index next separates the top 25% of these countries as measured by Cambria's proprietary long term valuation metrics. The Index then screens stocks with market capitalizations over $200 million. The Index is comprised of approximately 100 companies.
I contacted Faber, a managing member of Cambria Funds in order to utilize this list below which has the countries ranked by CAPE for July. You can also sign-up at theideafarm.com for this information on a regular basis.
As one can easily see, the United states is really quite overvalued in comparison with the rest of the world. The central thesis of GVAL is that one should invest on a global scale, in the countries that have the most value per CAPE. There are solid value propositions out there if one thinks on a global scale.
Here is a brief list of the top ten holdings for GVAL :
There are currently 101 companies within the fund and you can look at the entire list right here. With each one of these companies having a market capitalization of over $200 million they are poised to grow significantly as the global market corrects which will cause the discounted countries equity markets to return to normal levels and the United States as well.
The central thesis of the GVAL ETF is that the CAPE Ratio is a good indicator for aggregate value. Provided that this assumption holds true (and Shiller is not a Nobel Laureate for no good reason), then the United States will eventually correct to more historically appropriate levels and these emerging economies will also 'correct' and the portfolio will grow as a result.
Shiller may very well be right, perhaps the United States market is overvalued, but let's be more pragmatic then an individual who simply considers the S&P 500 to be overvalued. Since we can still seem to find value on a global scale let's consider investing in areas that offer value whether it be individual stocks or global markets.
While Shiller and other economists are attempting to find a reason for "lofty stock valuations," we might consider that more foreign money is being invested in the United States than in other countries. While Shiller continues to reiterate that the market is overvalued, the situation might be better considered in the global context. Based on the list shown above and a strategy outlined by Faber in his book on Global Value one might be able to craft their own strategy with respect to portfolio allocation, or they might be better served to utilize the GVAL ETF. In any case, history suggests that portfolios which simply mimic the S&P 500 are bound to fall sooner or later while portfolios that seek deep value will see strong returns over the long haul.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.