The cyclically-adjusted price-to-earnings (CAPE) ratio is a surprisingly controversial metric, but evidence suggests it is actionable for long-term investors.
Rather than simply dividing the current share price by 1 year of earnings like the normal P/E ratio, the CAPE ratio divides the current price by the past 10 years of inflation-adjusted earnings. It gives you a better idea of how cheap a stock or a market of stocks is relative to a full business cycle of earnings rather than potentially one year of peak or trough earnings.
This metric was popularized by Yale professor Robert Shiller, and over a century of data suggests that periods of high CAPE are associated with low forward returns for the S&P 500 (SPY) and periods of low CAPE are associated with high forward returns.
So, it doesn't give much insight on how to time the market in the short term, but it does give insight on the probability distribution of long-term forward returns for a given market.
But as interest rates have trended down in the United States, CAPE ratios have gone up a lot:
(Chart Source: Robert Shiller Online Data)
Critics of the CAPE ratio have argued that this renders the CAPE ratio rather irrelevant. Despite historically high CAPE ratios in recent years, S&P 500 stock returns have still been pretty good.
However, a great article by Meb Faber shows why it's important to think more globally. The United States is not your only pond to fish in.
Specifically, his research shows that from 1993 to 2018, investors who continually built a portfolio around the cheapest 25% of countries based on the CAPE ratio (orange line below) would have generated 3051% total returns over 25 years, compared to 961% returns from the S&P 500 (dark blue line below):
(Chart Source: Meb Faber, Cambria Investment Management)
That chart is logarithmic rather than linear, so it actually understates how well that strategy performed. The table outlines it more clearly. On an annualized basis, the low global CAPE strategy provided about 14% annual returns vs. 9% annual returns for the S&P 500. The volatility of the low global CAPE strategy was higher than the S&P 500, but its maximum drawdown was actually lower due to geographic diversification.
So yes, the S&P 500 gave good returns despite a historically high CAPE ratio over the past few decades. However, a basket of markets with lower CAPE ratios beat those returns. Everything is relative.
The research group at Star Capital has shown similar results. For 17 developed markets over a 36-year period between 1979 and 2015, buying country markets when the CAPE ratio was low vastly outperformed buying country markets when the CAPE ratio was high:
(Chart Source: Star Capital Research in Charts)
Sometimes many markets are highly valued or cheaply valued at the same time, and other times you can find pockets of value while others remain expensive.
Of course, that's no guarantee of future returns. It's plausible that this strategy could stop working, although I haven't seen a compelling case as to why it would.
The caveat is that it would be an awful, scary, gut-wrenching strategy to follow. Not necessarily due to volatility, but due to headlines. Everything you would read about your portfolio would be bad, as you'd be invested in places like Russia, Turkey, and Italy all the time. It's the quintessential strategy of buying when there is blood in the streets, on a global scale. Most people can't handle that, especially during multi-year periods where the strategy is underperforming.
The saving grace, however, is that this type of strategy is diversified, so one or two value traps (situations where a low-CAPE country provides poor long-term returns anyway) likely won't derail the strategy.
I have a bullish long-term outlook on a significant subset of emerging markets (EEM) from today's point of relatively low valuations and weak currencies relative to the U.S. dollar. Understandably, a lot of people are not fans of them. They point towards corruption and other undesirable aspects of the markets and often overlook the good aspects. Investing too heavily into any one emerging market is very risky, but diversifying into a basket of them, only putting a part of a fully-diversified portfolio into that basket, and consistently re-balancing into moments of weakness is historically a smart thing to do if you want high risk-adjusted returns.
I'd be interested to see more research on the topic of valuations in general. Is selecting the cheapest 25% of countries the important part, or merely avoiding the most expensive 25%? Maybe that kind of edited strategy would give fairly strong returns but would be easier to follow. It may also reduce turnover and minimize capital gains taxes.
As I'll discuss below, I like to look beyond pure valuation into other metrics to reduce my exposure to value traps. For example, I'm underweight Europe and much of EAFE (EFA) right now, even though the CAPE ratios there are pretty low for the most part. I like cheap markets on an absolute basis, but more importantly, I like cheap markets relative to their fundamentals, such as growth, debt, stability, and currency strength.
The Cheapest Markets Currently
There's a lot of capital at work in the United States, which pushes asset values up to high levels. There is broad participation in the stock market among investors, retirement accounts, pension plans, and foreign investors.
In many foreign markets, especially emerging markets, there is a lot less capital in equities. Local investors often buy real estate instead, resulting in rather low stock market participation. Thus, you can get a lot of earnings and dividends for each dollar you invest.
Star Capital maintains a great interactive map that shows you the cheapest markets based on a variety of metrics, including CAPE:
(Chart Source: Star Capital Valuation Map)
Right now, Russia (RSX), Turkey (TUR), Poland (EPOL), South Korea (EWY), Singapore (EWS), Spain (EWP), Malaysia (EWM), Israel (EIS), and Brazil (EWZ) have among the lowest CAPE ratios. The UK (EWU) and China (MCHI) aren't far behind.
But talk about portfolio headlines; everything you read about your investments would be sanctions, Brexit, debt bubbles, corruption, trade wars, and currency crises!
In addition to CAPE, I also like to track the market capitalization-to-GDP ratio for the markets. This metric can't be compared between countries because some countries get a lot more of their corporate revenue from abroad than others, but it's useful when comparing a country to its recent historical self.
By this metric, China had a clear bubble in 2007:
(Data Sources: World Bank and MSCI)
China's CAPE ratio was also north of 60 at that time, higher than the valuation the U.S. market was at during the dotcom bubble. In fact, most of the BRIC countries were overvalued in 2007 due to euphoria about their growth prospects.
MSCI's index for China took a decade to fully recover from that bubble in both USD and CNY:
(Chart Source: MSCI)
(Chart Source: MSCI)
What Makes a Good Market?
Rather than focusing strictly on the cheapest markets, I prefer to invest in markets that have an attractive balance of valuation, growth, debt, stability, and currency fundamentals. There are always trade-offs, but some countries offer better overall packages than others, and I look at multiple metrics for each of these five categories.
This process helps screen for bubbles, while allowing for investment in both deep value and growth at a reasonable price (GARP) markets.
Rather than just focusing on the CAPE ratio, I also take into account the current ratio of market capitalization-to-GDP relative to recent levels for that country, as well as the price-to-book ratio and the average dividend yield.
It's important to also consider the sector distribution in that country. The cheapest countries may not have much technology or healthcare exposure, for example, and instead, may have a lot of banks and commodity producers, which generally trade for lower valuations worldwide.
Valuation doesn't say much on its own without taking into account growth. Some countries deserve higher valuations because they have better growth and demographics.
Peter Lynch popularized the PEG ratio for companies, which is the P/E ratio divided by the growth rate. Applying this to countries means dividing either their current P/E ratio or their CAPE ratio by their expected long-term GDP growth rate, as judged by the IMF or other research. This gives you a kind of PEG ratio for various country stock markets, which is a rough but interesting metric when applied on a broad scale rather than individual stock.
Some countries have grown mainly because of debt, which is unsustainable when it reaches high levels. The Bank for International Settlements has a good database that lets you look up household debt, corporate debt, and government debt as a percentage of GDP for dozens of countries. It also has metrics for combined advanced markets and combined emerging markets:
(Data Source: BIS Statistics Warehouse)
Some countries are bastions of stability without much drama. They lack major political instability, have low levels of terrorism, don't have a lot of international conflicts, and have a strong legal system and a good history of respecting capital. Other countries have shortcomings in one or more areas.
All else being equal for risk-adjusted returns, it's rational to pay up to a certain extent for more stable countries and to discount less stable countries.
A key risk for international investing, especially in emerging markets, is for their local currency to significantly weaken compared to yours, or especially compared the dollar, since many of their governments and corporations hold dollar-denominated debt.
For that reason, it's useful to monitor several currency metrics. The metrics I focus on include a country's current account balance, real interest rates, external dollar-denominated debts, and the size of foreign exchange reserves relative to GDP and broad money supply.
Most currency crises are obvious in hindsight, and develop in countries that have big current account deficits, that have high dollar-denominated debt, and that don't have large foreign exchange reserves.
It's also worth noting differences in purchasing power, because countries with undervalued currencies have an advantage with exports and may at least partially revert to their historical mean.
One of the most interesting and humorous metrics is the GDP-adjusted version of the Big Mac Index, calculated twice annually by The Economist:
(Chart Source: The Economist)
The Russian ruble, for example, is 70% undervalued based on the raw calculation and still 50% undervalued when discounted for Russia's lower GDP per capita than the United States. This is despite the fact that Russia has among the lowest debt levels in the world, a positive current account balance, positive real interest rates, and very high levels of foreign exchange reserves relative to both GDP and their broad money supply. Investors are spooked by sanctions, perhaps rightfully so, but that potentially allows for strong upside potential, should those tensions diminish rather than intensify. It may be an asymmetrical opportunity, in other words, although one most likely best kept as a small position.
U.S. investors in Russian equities would likely benefit if the ruble were to strengthen compared to the dollar. On the other hand, as long as the currency remains this cheap, Russia has a big price advantage with wheat exports and in other commodity markets.
Putting it All Together
The reason that buying cheap markets historically works well is a sum-of-parts outcome. Cheaper markets typically have higher dividend yields, their low valuations are more likely to expand than contract, and their weak currencies are more likely to at least partially revert to the mean than sink further when considered over a long timeline. In contrast to the common saying that trees don't grow to the sky, the majority of markets do not fall permanently into an abyss, either.
This chart, for example, breaks down Research Affiliate's estimate of long-term forward emerging market performance based on the sum of their estimated parts in their asset allocation tool:
(Source: Research Affiliates)
Because investors tend to overshoot in both directions, the top-performing markets are often priced too optimistically, while troubled markets are often priced too pessimistically.
Many investors have little or no foreign exposure.
And for investors who do have foreign exposure, they usually just hold something broad like the Vanguard Total International Stock ETF (VXUS), which is weighted by market capitalization and thus heavily invested in Japan (EWJ)), the UK, and other large slow-growth markets without any kind of valuation filtering mechanism.
Investing a portion of your foreign equity allocation into single-country ETFs from iShares or other providers representing some of the cheapest markets, or into ETFs that have unique filtering mechanisms like the Cambria Global Value ETF (GVAL), might give investors better returns if history offers any insight here.
Personally, I'm optimistic about several foreign markets over the long term. There is a lot of value in many regions of the world, with a good balance of high dividends, low debt, strong currency fundamentals, and substantial growth potential.
Disclosure: I am/we are long VWO, IEMG, RSX, TUR, INDA, EWY, EWZ, EWS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.