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Cape ratio did well last year
The Cape ratio is one of MoneyWeek's favourite valuation metrics. Matthew Partridge explains how it works, and why it's done so well this year.
The cyclically-adjusted price/earnings ratio (Cape) is one of our favourite valuation tools here at MoneyWeek, particularly when considering which individual countries might prove to be rewarding investments. In short, numerous studies have shown that future stockmarket returns tend to be higher if you invest when Cape ratios are low (ie, a market is cheap), than if you buy at a high Cape (when the markets is expensive). Most of the work on Cape has been done in the US, but more recent data suggest that the relationship holds true for global markets too. So how did Cape perform this year, and which markets look cheap for 2017?
The four cheapest markets at the end of 2015 were Russia, Brazil, Peru and Poland, according to data from Mebane Faber of Cambria Investment. Russia and Brazil are the largest of these, and each had an outstanding year, enjoying total returns of 46.9% and 60.1% respectively (in dollar terms). Of the smaller countries, Peru also had a very good year, returning 57.9%. The one exception was the Polish stockmarket, which fell by 5%.
How about the four most expensive markets the US, Japan, Ireland and Denmark? Well, due to the recent Trump rally, the US has managed a 10.2% total return. Japan also kept its head above water, returning 3.3%. However, after a very strong performance over the past few years, the Irish stockmarket fell by 8.3%. And if you had been unfortunate enough to put your money in the Danish stockmarket, you would have lost nearly a fifth (17.2%) of your investment.
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So that's a pretty good hit rate for Cape as an investment indicator. More broadly, while there were a few exceptions (such as Turkey and New Zealand), the markets with lower Cape ratios at the end of last year generally did better than those with high ones. Indeed, if you plot returns against Cape ratio for 2015 for the 40 countries that Faber covers, there's a significant correlation between the starting Cape and total returns.
Valuation ratios with any predictive value at all are rare so if the Cape ratio provides at least some sort of guide to future returns, which markets should do well in 2017? The latest data suggests that the Czech Republic and Portugal are the two cheapest markets, each trading at only four times their ten-year average earnings. Russia, Italy and Poland also look like bargains on Cape ratios of five.You might therefore want to consider the iShares MSCI Eastern Europe Capped UCITS ETF (LSE: IEER). As for what to avoid?,The US and Denmark have Capes of 42 and 44 respectively.
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