Does cheapness predict subsequent outperformance?

November 21, 2013 4:10 pm

Does cheapness predict subsequent outperformance?

By Dominic Picarda

Europe looks cheap, but the US is pricey

Nothing sets off alarm bells quite like investors claiming that old valuation rules no longer apply. The classic case of this was during the technology bubble of the late 1990s. Faced with internet firms that made little or no profit, analysts spurned traditional valuation tools and cooked up new techniques based – among other things – upon website clicks. When investors woke to the incoherence of this “new paradigm”, technology stocks collapsed.I thought I could hear a faint bell ringing just lately during a very public debate over the merits of the cyclically-adjusted price/earnings ratio, or Cape. This tool – popularised by 2013 Nobel Laureate Robert Shiller – values stock markets using their average real earnings over multi-year periods, typically a decade. Cape rightly identified US equities as being too dear ahead of the Wall Street meltdowns of 2000-02 and 2007-09.

Fronted by Professor Jeremy Siegel of Pennsylvania University’s Wharton School, equity bulls today argue that Cape is flawed and should be cast aside. The cynic in me believes it is easy to see why. The Cape for the S&P 500 is currently 24.4, more than one standard deviation above the long-run average of 16.5. For die-hard bulls, this is an inconvenient truth. I calculate that this level of valuation is consistent with annualised real returns on US large-cap shares over the next decade of minus 3.4 per cent.

In an attempt to add something to this debate, I have looked at Cape’s message for stock markets outside the US. Taking 26 mainly developed-country indices since the mid-1960s, I first asked which length of Cape has been best for forecasting subsequent returns. It has become conventional to use 10 years of earnings, but I was curious to know whether using between two and nine years’ worth worked better.

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As it happens, 10 years of earnings works best with Cape. Both for determining likely returns in the near future and farther out, 10-year Cape was most predictive for more markets than any other variant. There were exceptions: a three-year Cape has worked better in Japan and Norway, while a six-year Cape has been best for Finnish equities. This is mere cherry-picking, however. The 10-year variety is a perfectly good blanket option.

Having confirmed the best period for Cape, I then asked the really important question: can we boost our performance by consistently investing in markets with the lowest Capes? I split developed-country stock markets into four camps at the start of each year, according to their Capes. I then looked at the price returns in sterling terms from buying into each of the four camps and holding on for the next 12 months.

The initial results were striking. Buying the lowest-rated markets each year would have made an annualised return (before dividends) of 12.1 per cent, compared to just 8.2 per cent for developed-market shares as a whole. True, this came at the cost of higher volatility: 19.2 per cent annualised against 16.8 per cent. And, while it thrived after the dotcom collapse of 2000, the strategy suffered more painful losses than developed stocks as a whole during the stock market traumas of 1987 and 2008.

In 2011 and 2012, buying the six lowest Cape markets also did worse than developed markets generally – and indeed worse than the dearest Cape markets (think US and Japan). Investing in the second-cheapest camp – which has included Germany and the UK – seems to have been the best approach.

So, which are the cheapest developed-world stock markets according to Cape today? Unsurprisingly, the eurozone casualties loom large: Austria, Ireland, Italy, the Netherlands, Portugal and Spain. But investing in those markets is effectively a bet on European recovery. In 2013 so far, it has paid off nicely, delivering a capital gain of some 23.8 per cent versus 18.6 per cent for developed markets more widely.

Rather than wondering whether buying low Cape stocks will succeed in 2014, the critical question for me is how to square the healthy returns implied by the low Capes in the eurozone with the poor returns signalled by the same indicator in the world’s most influential market, the US.

Dominic Picarda edits Investors Chronicle’s Market Tactics report.