This Strategy Tripled The S&P 500 Over 25 Years

Apr. 26, 2019 2:51 AM ETARGT, EEM, EFA, EWJ, GVAL, INDA, RSX, SPY, VXUS, EIS, EPOL, EWM, EWP, EWS, EWU, EWY, EWZ, MCHI, TUR114 Comments

Summary

  • From 1993 to 2018, investing in the cheapest 25% of countries based on the CAPE ratio would have tripled your money compared to investing in the S&P 500.
  • Due to underperformance of foreign stocks over the past decade, there is very little interest in investing outside of the United States. That may be a mistake.
  • Substantial evidence suggests that bottom-fishing in out-of-favor markets is likely to do well over the next decade, but it's a psychologically challenging strategy to follow.

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:

CAPE Interest Rates

(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):

Global CAPE Chart

(Chart Source: Meb Faber, Cambria Investment Management)

This article was written by

Lyn Alden Schwartzer profile picture
43.74K Followers
Author of Stock Waves
High-probability investing where fundamentals and technicals align!
With a background that blends engineering and finance, I cover value investing with a global macro overlay. My focus is on long-term fundamental investing, primarily in equities but also in precious metals and other asset classes when appropriate.

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My work can be found at LynAlden.com, ElliotWaveTrader.net, and within the Seeking Alpha marketplace where I work with the Stock Waves team to blend their technical analysis with my fundamental analysis for high-probability long-term setups.

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.

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