I have discussed the CAPE ratio before as a method to determine overvaluation/undervaluation of various stock markets. You can read my article I wrote about CAPE here.
The current data shows that the following markets are cheapest with regards to CAPE:
- Czech Republic
The most expensive markets are:
So what is this all about. CAPE measures levels of overvaluation and undervaluation. IT IS NOT A MARKET TIMING TOOL. Overvalued markets can stay overvalued and get even more overvalued. Conversely, undervalued markets can stay undervalued for extended time periods.
What we can determine is that over time your returns can be expected to be low or even negative if you are buying a historically overvalued market.
I use the measure to help find undervalued markets to buy. It has been shown that purchasing markets that are cheap on a historical basis tend to outperform overvalued markets.
Meb Faber has written a white paper that explains the CAPE ratio and how to use it as a trading tool.
Investors spend an inordinate amount of time and effort forecasting stock market direction, often with very little success. The conventional efficient market theory is that markets are not predictable and cannot be forecasted. Value has no place in the efficient market ivory tower, but
does it seem reasonable for an investor, or perhaps a retiree, to have allocated the same amount of a portfolio to stocks in December 1999 versus in 1982? Of course not.
However, valuation is best used as a strategic guide rather than as a short-term timing tool. It is most useful on a time scale of years and decades rather than weeks and months (or even days). While we can formulate a hypothesis for where the S&P 500 ‘should’ be trading, the animal spirits contained in the marketplace invariably cause prices to deviate quite substantially from
‘reasonable’ levels, often for years and even decades (current situation in the US).
What we find is no surprise, it very much matters what price one pays for an investment! Indeed it is an almost perfect stair step - future returns are lower when valuations are high, and future returns are higher when valuations are low.
You will note that Faber, in his paper, specifically says in the paper that the tool is useful for periods of years or decades and is not a short term trading tool.
The problem with using CAPE as a tool is that "average investors" are not patient and cannot "be right and sit tight". This was a problem I had for many years. I think the biggest issue with investor patience is not having reasonable expectations for future returns.
So the way I use CAPE is to sell overvalued markets and buy undervalued markets. I look at this quarterly and rebalance as necessary.
If you like visuals check this one out from the before mentioned white paper.
The higher the CAPE the lower the future returns. The chart above is based on 130 years of data through all types of economic eras. The US CAPE is currently 28 which indicates retunrs over the next 10 years will average 3.3%. If most of your money is in US equities you are picking up dimes in front of a steamroller.