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ABSTRACT
Over seventy years ago Benjamin Graham and David Dodd
proposed valuing securities with earnings smoothed across
multiple years. Robert Shiller popularized this method with his
version of the cyclically adjusted price-to-earnings ratio (CAPE)
in the late 1990s, and issued a timely warning of poor stock
returns to follow in the coming years. We apply this valuation
metric across more than thirty foreign markets and find it both
practical and useful. Indeed, we witness even greater examples
of bubbles and busts abroad than in the United States. We then
create a trading system to build global stock portfolios based on
valuation, and find significant outperformance by selecting
markets based on relative and absolute valuation.
Mebane T. Faber
Shiller maintains a website with an Excel download that includes historical data with formulas
illustrating how to construct his ten year CAPE. For a step-by-step guide Wes Gray at Turnkey
Analyst has a good post that walks through the steps necessary to construct the metric.
One common criticism of the CAPE is that the measurement period of ten years is too long.
Critics claim recessions and expansions have an outsized impact long after they have faded from
memory. Estimating Future Stock Market Returns by Adam Butler and Mike Philbrick tackles
the issue of different measurement periods from one year up to thirty (as well as other valuation
models). Critics also claim adjustments to CPI and accounting rules render comparisons across
decades, or even centuries meaningless. While we agree there may be some variation, later in
the paper we examine the CAPE in over 30 foreign markets with supporting results.
Figure 1 below is a chart of the CAPE going back to 1881. The long-term series spends about half
of the time with values ranging between 10 and 20, with an average and median value of about
16. The all-time low reading was 5, reached at the end of 1920, and the high value of 45 was
reached at, you guessed it, the end of 1999.
FIGURE 1
US 10-YEAR CAPE
1881 - 2011
Source: Shiller
Asset allocators that believe in efficient markets allocate the same percentage of assets to
equities when valuations are high as they do when valuations are low. But does that seem even
remotely reasonable looking at the above chart?
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FIGURE 2
US STOCK REAL RETURNS VS. 10-YEAR CAPE
1881 - 2011
Source: Shiller. Index returns are for illustrative purposes only. Indices are unmanaged and an investor cannot
invest directly in an index. Past performance is no guarantee of future results.
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.
FIGURE 3A
US STOCK AVERAGE REAL COMPOUND RETURNS VS. 10-YEAR CAPE
1881 - 2011
CAPE
<5
5 to 10
10 to 15
10 Year fwd
Real CAGR
15.8%
10.5%
26.4%
10.6%
8.3%
6.7%
6.5%
8.1%
15 to 20
31.0%
6.4%
4.7%
5.2%
5.3%
5.2%
20 to 25
15.5%
1.6%
5.4%
4.9%
4.3%
2.7%
25 to 30
5.4%
1.3%
-1.0%
-1.3%
1.5%
3.3%
30 to 40
3.1%
1.9%
0.3%
-1.1%
-0.5%
-0.3%
40 to 50
0.8%
-12.5%
-17.0%
-4.8%
-1.5%
-3.5%
Source: Shiller. Index returns are for illustrative purposes only. Indices are unmanaged and an investor cannot
invest directly in an index. Past performance is no guarantee of future results.
FIGURE 3B
US STOCK AVERAGE REAL COMPOUND RETURNS VS. 10-YEAR CAPE
1881 - 2011
Source: Shiller. Index returns are for illustrative purposes only. Indices are unmanaged and an investor cannot
invest directly in an index. Past performance is no guarantee of future results.
While more sophisticated models can be built, below is a simple figure of an inverse CAPE and
future 10-year real stock returns shockingly similar. John Hussman has a few good articles on
this topic: Estimating the Long Term Returns on Stocks and The Likely Range of Market
Returns in the Coming Decade Joachim Klement also recently published the paper, Does the
Shiller-PE Work in Emerging Markets? that performs a similar analysis.
FIGURE 4
US STOCK 10-YEARE REAL COMPOUND RETURNS VS. 10-YEAR CAPE
1881 - 2011
Source: Shiller. Index returns are for illustrative purposes only. Indices are unmanaged and an investor cannot
invest directly in an index. Past performance is no guarantee of future results.
compared to when there is either high inflation or outright deflation. Rob Arnott of Research
Affiliates touches on this important topic in his white paper, King of the Mountain. Two other
books speak of CAPEs and inflation/deflation levels. The first is Unexpected Returns:
Understanding Secular Stock Market Cycles by Ed Easterling, and John Mauldins Bull's Eye
Investing: Targeting Real Returns in a Smoke and Mirrors Market.
FIGURE 5
SHILLER CAPE VS. INFLATION LEVELS
1880 - 2011
Source: Shiller, Arnott. Index returns are for illustrative purposes only. Indices are unmanaged and an investor
cannot invest directly in an index. Past performance is no guarantee of future results.
GLOBAL CAPE
There is very little in the literature regarding global CAPEs for international equity markets. One
such resource is Russell Napier, who authored Anatomy of the Bear: Lessons From Wall Street's
Four Great Bottoms, and who discusses global CAPEs in a video here. We also found two great
recently published papers by Joachim Klement Does the Shiller-PE Work in Emerging
Markets?, and Value Matters: Predictability of Stock Index Returns by Angelini, Bormetti,
Marmi, and Nardini.
We examined 32 countries with data from Global Financial Data and Morningstar, including as
much data as we could find. We realize there is some bias in this study (if you have German PE
data to 1685 or French to 1724 please contact us), but we did the best with what we have. We
utilized local real returns (and found dollar based real returns to be nearly identical) to net out
the effects of inflation.
While only two had century long data (US and UK), most of the other countries go back to the
1970s and 1980s.
FIGURE 6
GLOBAL COUNTRIES INCLUDED IN STUDY AND 10-YEAR CAPE
AS OF JUNE 2012
Country
Australia
Austria
Belgium
Brazil
Canada
Chile
China
France
Germany
Greece
Hong Kong
India
Indonesia
Ireland
Italy
Japan
Malaysia
Mexico
Netherlands
Portugal
Russia
Singapore
South Africa
South Korea
Spain
Sweden
Switzerland
Taiwan
Thailand
Turkey
UK
USA
Latest
Min
Max
Median
12.87
7.66
9.06
11.63
17.31
22.81
14.30
10.53
12.07
2.04
15.27
18.63
24.25
4.97
6.54
14.09
20.15
20.77
9.95
7.20
7.16
12.18
16.58
15.14
8.49
14.17
14.37
13.69
15.09
13.64
12.41
20.88
7.65
6.04
4.88
11.04
5.83
9.71
14.30
6.20
7.83
1.95
8.55
12.69
5.05
3.02
5.92
13.27
7.77
11.69
4.62
7.02
5.13
9.40
10.16
4.74
7.25
4.82
7.12
9.18
3.00
8.24
4.43
4.72
31.60
59.11
29.49
29.73
63.33
32.95
61.98
57.16
56.86
39.81
34.55
47.80
34.96
18.25
52.91
94.25
26.50
35.33
38.52
39.36
22.88
37.80
24.12
27.65
40.06
74.18
57.94
42.28
17.97
42.96
28.69
45.08
17.15
26.80
14.89
17.34
19.85
20.93
24.40
19.92
17.90
15.91
18.16
24.56
16.37
10.94
21.66
43.89
18.49
19.62
11.95
16.43
9.15
21.96
16.22
17.84
17.33
19.54
18.16
19.43
11.48
17.02
11.84
14.63
Source: Global Financial Data Index returns are for illustrative purposes only. Indices are unmanaged and an
investor cannot invest directly in an index. Past performance is no guarantee of future results.
We examined all the countries on a yearly basis since 1980, CAPE levels, and future returns. The
sample includes approximately 10 counties in 1980, 20 in 1990, and 30 by 2000. The results are
in the table below and largely confirm the US data. Buy low, sell high.
FIGURE 7
10-YEAR CAPE LEVELS AND FUTURE AVERAGE REAL COMPOUND RETURNS FOR 32 COUNTRIES
1980 - 2011
Avg CAPE
by Bucket
<10
10 to 15
15 to 20
20 to 25
25 to 30
30 to 40
40 to 50
>50
%
occurrence
10.2%
20.5%
25.2%
18.3%
11.0%
7.5%
4.4%
2.0%
1 Year
Real CAGR
25.9%
22.8%
11.2%
4.4%
-1.3%
3.0%
-3.3%
-4.5%
3 Year
Real CAGR
17.0%
13.8%
10.8%
6.8%
0.7%
-1.1%
-3.4%
-12.3%
5 Year
Real CAGR
17.1%
12.2%
10.6%
5.6%
3.4%
-0.8%
0.0%
-6.4%
7 Year
Real CAGR
13.4%
11.2%
8.8%
6.5%
3.4%
1.7%
0.2%
-1.9%
10 Year
Real CAGR
10.9%
9.6%
8.0%
5.7%
3.3%
2.1%
-0.2%
-3.1%
Source: Global Financial Data, Morningstar. Index returns are for illustrative purposes only. Indices are unmanaged
and an investor cannot invest directly in an index. Past performance is no guarantee of future results.
We found most CAPEs averaged around 15-20, bottomed out around 7, and maxed out around
45 (and a few made the United States bubble in the late 1990s look pathetic in comparison, like
Japan reaching a value of nearly 100 in 1989).
THE BEST OF TIMES, THE WORST OF TIMES
Similarly, do the extremes in valuation signal bubbles and generational buying opportunities?
We examined at the database for all instances where CAPEs were below 5 at the end of the
year. We also included the longer US and UK datasets here for some context. We only found
nine out of about 850 total market years: the US in 1920, the UK in 1974, the Netherlands in
1981, South Korea in 1984, 1985, and 1997, Thailand in 2000, Ireland in 2008, andGreece in
2011.
Can you imagine investing in any of these markets in those years? In every instance the news
flow was horrendous and many of these countries were in total crisis.
Now what would happen if you invested in these seemingly deplorable markets, the literal worst
of the most disgusting geopolitical headlines? Below are local country real returns (net of
inflation):
CAGR
1 Year
3 Year
5 Year
10 Year
35%
30%
20%
12%
Likewise, there are only six instances where countries ended the year with CAPE values over 50.
Malaysia in 1993, Japan in 1986-1990, 1999, 2005, and 2006, Italy in 2000, India and China in
2007, and Austria in 1991. The Internet bubble in the US narrowly missed the mark with a value
of 45 in December 1999. But wow talk about a list of awful times to invest!
Below are local country real returns, on average:
CAGR
1 Year
3 Year
5 Year
10 Year
-15%
-9%
-6%
-3%
Source: Global Financial Data, Morningstar. Index returns are for illustrative purposes only. Indices are unmanaged and an
investor cannot invest directly in an index. Past performance is no guarantee of future results.
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FIGURE 8
PORTFOLIOS SORTED ON CAPE LEVELS, REAL RETURNS
1980 - 2011
Source: Global Financial Data, Morningstar. Index returns are for illustrative purposes only. Indices are unmanaged and an
investor cannot invest directly in an index. Past performance is no guarantee of future results.
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FIGURE 9
PORTFOLIOS SORTED ON CAPE LEVELS, REAL RETURNS
1980 - 2011
Source: Global Financial Data, Morningstar. Index returns are for illustrative purposes only. Indices are unmanaged
and an investor cannot invest directly in an index. Past performance is no guarantee of future results.
For the most part, adding the absolute CAPE level filter results in better performance with lower
drawdowns. This is to be expected as the portfolio could be sitting in 20%, 50%, or even 100%
cash (like 1999 or 2007). In this case the returns are higher as well. As many investors look at
this table and salivate over the prospect of 15% real returns, recall Figure 6 and note that most of
the cheapest countries fall in the troubled Eurozone. How many investors have the stomach to
invest in these countries with potential for the markets to get even cheaper? How many
professional investors would be willing to bear the career risk associated with being potentially
wrong in buying these markets?
Figure 10 on the following page depicts the equity curves from taking the cheapest 33% of
countries (also with filter), the most expensive 33% of countries, and the equal weight
benchmark.
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FIGURE 10
PORTFOLIOS SORTED ON CAPE LEVELS, REAL RETURNS
1980 - 2011
Source: Global Financial Data, Morningstar. Index returns are for illustrative purposes only. Indices are unmanaged and an
investor cannot invest directly in an index. Past performance is no guarantee of future results.
SUMMARY
Warren Buffett famously said, Price is what you pay. Value is what you get. Over periods of
years and decades it is evident that an investors real return is heavily dependent on the price
paid for the asset. Investors can use CAPE valuation as a guidepost for both opportunities arising
from negative geopolitical events, as well as a sanity check against bubbling stock markets.
Comparing global equity markets on a relative basis allows the portfolio manager to create
portfolios of cheap stocks markets, while avoiding or even shorting expensive markets.
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FIGURE A
1975 - 2011
33%
B&H
Book
Earnings
Cash Flow
Dividends
CAGR
12.7%
13.5%
15.6%
13.2%
14.3%
STD
22%
24%
24%
25%
24%
MaxDD
47%
46%
50%
46%
49%
25%
B&H
Book
Earnings
Cash Flow
Dividends
CAGR
12.7%
15.4%
14.3%
14.0%
14.9%
STD
22%
25%
26%
25%
24%
MaxDD
47%
43%
61%
46%
46%
10%
B&H
Book
Earnings
Cash Flow
Dividends
CAGR
12.7%
18.1%
16.4%
13.5%
12.9%
STD
22%
29%
28%
34%
26%
MaxDD
47%
38%
54%
55%
48%
Source: Global Financial Data, Morningstar, Fama & French. Index returns are for illustrative purposes only. Indices are
unmanaged and an investor cannot invest directly in an index. Past performance is no guarantee of future results.
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