No valuation measure will help you time the market. But the cyclically adjusted price/earnings ratio (Cape) has proved a good guide to long-term returns in equity markets around the world, says Jonathan Compton.
If you own a bicycle, you need to acquire some simple technical knowledge, such as how to pump up or repair the tyres, adjust the height of the seat or handlebars, tighten the brakes or put the chain back on. Most cyclists can perform these undemanding tasks with their eyes closed. When it comes to making money from stockmarkets, however, most investors – even those paid to look after other people’s money – tend to react nervously to rigorous analysis of markets, sectors or stocks. Often unaware of how it actually works and afraid to appear foolish, investors resort either to bluffing or a general dismissal of analytical tools designed to establish whether equities or markets are good value at the current price – even though some of these measures have an impressive record in helping to forecast market returns or mitigate losses.
One well known and frequently used measurement, for instance, is the price-to-book ratio. This is calculated by adding up a company’s total assets and then subtracting intangible assets such as patents and debts and other liabilities. This amount, divided by the number of shares, is the book value per share, which in turn is divided into the share price.
A price-to-book value below one means a company is trading below the value of its assets (and is therefore a bargain), while above that number it is trading at a premium. As a rough test this can be useful, but it has many flaws. For a company such as Amazon, which over the last five years has never traded below 12 times book (it is now on 19.8 times), using book value per share as a guide to buy or sell would have been an enormous mistake because the share price has risen five-fold. The same applies to many other valuation tools from Tobin’s Q (a refinement of the simple book value gauge) to Altman-Z scores (a useful indicator of financial distress). No single valuation tool provides a wholly accurate signal of when to buy or sell.
A reliable indicator of long-term returns
Yet there is one system which, correctly used, has proved a surprisingly reliable indicator of likely long-term future market returns; it also serves as a switching guide between different national markets and even between sectors and stocks within a single market. This is Cape, an acronym for the cyclically adjusted price/earnings ratio. Its origins lie with the doyens of value investors, the pioneering Benjamin Graham and David Dodd, who were trying to bring a more rational approach to calculating a firm’s intrinsic value and thus whether its share price was cheap or expensive.
They published their findings in two books, Security Analysis and The Intelligent Investor, in 1934 and 1949 respectively. Dry as dust though both are, they attracted many disciples (of which the most famous is Warren Buffett) who successfully ran with their ideas. They believed that using a company’s price/earnings multiple (or p/e) with a single year’s earnings to estimate value was too volatile a measure to indicate a company’s true earning power and future capacity to pay dividends (investors paid far more attention to income then than today).
So they started to look at long-term averages for earnings, often five to ten years, and adjust these for inflation. Smoothing out earnings over a longer period reduced the inherent volatility and inaccuracy of looking at a single year’s earnings and, crucially, allowed them to assess how well a company performed over a full business cycle. Like many good ideas, its utility only became obvious with hindsight.
The Shiller p/e
The baton was then taken up by Yale professor Robert Shiller, which is why Cape is sometimes known as the Shiller p/e. He started to analyse the US market, looking for patterns to predict future returns. Thanks to Shiller, Cape moved into the mainstream. His reasoning was clear while his pithier expressions were widely used (the then Federal Reserve chairman Alan Greenspan used Shiller’s phrase “irrational exuberance” in 1996). Behind Cape is another simple idea: that markets revert to the mean. When they have soared, they will tumble, and vice versa, always returning to the long-term average. As all investors discover, this is an unbreakable truism.
In 2000, the Cape ratio for the American stockmarket rocketed to nearly 45 at the peak of the technology boom, then rapidly halved in the subsequent crash. Given that the long-term average since 1880 was around 16 times and the growing band of Cape aficionados had been screaming correctly that the market was wildly overpriced for several quarters, Cape became an increasingly popular valuation tool. This popularity was reinforced in 2007 when Cape followers warned of a crash before the global financial crisis actually happened.
“At the peak of the dotcom bubble the Cape of the US market reached a record 44”
The Cape ratio had hit a peak in America of 27 before again halving. Moreover, after the crash Cape had fallen to a 20-year low, and so was bellowing a “buy signal” at a time of maximum investor panic. Its credentials were thus assured. Now you can hardly pick up any academic research on stockmarkets whose author does not rely on the level of Cape as a reason to recommend or advise against a given market.
So why aren’t the rest of us all poring over Cape data? Because while it will give you a very good idea of how well you will do in the long-term if you buy now, as a predictor of when markets will rise or fall it is utterly hopeless. It is not a timing tool; US equities have been expensive for years, for instance. Cape fans have wrongly been sounding caution since 2011 when Cape reached a high of 23. If you had sold then the result would have been to miss out on one of the greatest bull markets in history.
What Cape can’t capture
Many analysts have piled in to point out other flaws. It can be less effective in resource-based markets or those where a handful of stocks dominate the indices. For example, three years ago, stripping Amazon out of America’s main index reduced Cape by four, making the market look less expensive. In Denmark the skew created by large pharma companies makes that market look eternally pricey. Then there are accounting changes affecting earnings that Cape cannot always capture while events such as buybacks can also give an inflated reading of earnings-per-share (EPS). If a market has enjoyed a very long period of growth in EPS Cape can be misleading. Similarly, Cape cannot easily take into account the new tax breaks under US president Donald Trump which helped boost profits and thus valuations, nor that in America and elsewhere profit forecasts have consistently undershot results, so that an apparently high Cape turned out to be lower and thus less alarming.
Three key advantages
For all its known flaws, Cape provides three key advantages. The first is that it mathematically measures how cheap or expensive a given market is relative to its own history. The US market currently trades on a Cape of 31.7. The historical mean is 16. Since 1880, it has been briefly more expensive only twice: in 1929 and in 2000. Both ended in tears and crippling losses for investors.
Yet until recently this extreme level has not worried me at all because of interest rates. Market valuations tend to be high when interest rates are low and following the 2008 financial crash, America and many other markets have enjoyed a prolonged period of record low interest rates. Leading central banks have also been printing money in unprecedented quantities This record liquidity has sustained markets expensive in Cape terms. Yet now I am concerned.
“Buying the markets with the lowest Capes and selling those with the highest boosts long-term returns”
This is not just because interest rates have nudged up, but because of other signs of excess. These signs include the number of buyouts using extreme borrowing ratios, the record low premium on “junk” bonds relative to safer assets, and some extreme valuations for “zombie companies” (businesses whose cash flow fails to even cover their interest costs). Most important of all is the liquidity backdrop. Growth in broad money globally – an indicator of credit and thus business activity – recently touched zero. As this has never happened before I cannot tell you what it means other that, like when you are pedalling along at speed and your tyre explodes, it’s never a good sign.
The second indicator is that Cape is a very useful switching tool between countries. Simply put, if an investor buys into those markets with the lowest ratios and sells those with the highest, the historical evidence shows that five- and ten-year returns will be significantly better as much as 60% of the time. But applying this maxim more recently you would have been mired in many underperforming emerging markets and have missed out on America’s bull run.
Blending Cape with other valuation measures
The third area where Cape can add real value is in predicting probable future returns. Many analysts, noting the flaws in simple Cape, have created blended formulas (which do seem an improvement), overlaying other key ratios such as price-to-book and sometimes dividend yields. Here Cape really comes into its own in allocating probability ranges for future returns as far out as 15 years which have proven remarkably accurate. The 1999 forecast for US returns over the next ten years was -6.3%, and the actual result was -3.8%. Had investors acted they would have avoided a “lost decade”.
What Cape is telling us now
Putting all this together, which markets are cheap or expensive and thus likely to produce low or high returns over the next decade? The absolute stand-out for being chronically overpriced is America. Pure Cape and blended Cape formulas suggest annualised returns over the next ten years of between -4% and 6.6% (Professor Shiller is shooting for about 2%).
This may seem a wide range but the message is that the most probable return from investing in the US market over the next decade will be a big fat zero. In theory you should be switching from America to those markets where there are near record-low readings. But just as Cape can remain extremely high for years, so the converse applies.
Hence I would override the formulas and apply a little common sense to several of those markets which have had, and continue to show, readings in single digits as they can roughly be classified as fruitloops.
These include Turkey as it trundles towards default; Russia, where a company’s very existence remains at the whim of President Putin; so too, to a lesser extent, Hungary under Prime Minister Orban. Argentina, the world’s serial defaulter, also deserves its low rating. But in the low to mid-teens there are several countries which are well below their long-term averages and cheap on Cape measures.
In Brazil, Cape is pointing to an annualised return of over 10% for the next ten years. In Asia, Korea at around 12 times is as cheap as it has been in more than a decade, while Japan has only been cheaper in two years of the last 25. The standout, however, is Singapore, where the Cape ratio has been in a prolonged decline and only briefly worse at the bottom of the 1997-1998 and 2008 Asian and financial crashes.
“The most probable return from investing in the US over the next decade will be a big fat zero”
Yet most interesting of all is the clear value as measured by Cape for developed Europe. Germany at 19 is almost at the same level as following the low after the 2000 technology crash (the high was 59) and the UK on 16 is clearly pricing in very little, given a 25-year high and low of 28 and 11 respectively. It is no coincidence, therefore, that Warren Buffett has announced he is taking a much closer look now, having been largely uninterested in the UK for most of his career.
What Cape is showing is intuitively what we all know. That this extraordinary American bull market is, on Cape and historic data, exceptionally frothy and overdue a prolonged period of weakness. On some matrices the excess has eclipsed the extremes of 1929 and 2000. This may continue for several months or quarters, as Cape can never tell us when to sell; but it does suggest a gradual reduction is in order in favour of these cheaper markets. If you are inclined to follow the system faithfully, then you can bet on the fruitloops, but I can see little point when safer and steadier returns can be forecast from these more mature markets. The box below outlines how you can invest in them.
The funds to buy now
As I have concentrated on Cape valuations in national markets I am recommending funds and exchange-traded funds (ETFs) to capture them rather than attempt to shoot out the lights with individual stocks. With the funds, I maintain a bias towards those investing in small to mid-cap companies; with the ETFs my criteria are that they have well capitalised managers, properly reflect the relevant index and charge low fees. My suggestions are in the same order as the recommended countries above.
For Brazil the choices are slim but the JPMorgan Brazil Investment Trust (LSE: JPB) fits the bill. It has performed in line with the index over the last five years (in other words, it has moved sideways); the only real risk is its small size (£21m). This may in part explain the current 18% share price discount to its net asset value (NAV), which more than compensates.
I’ve always had a slight bias, possibly unfairly, against active managers in Korea, many of whom have felt dodgy, so I prefer an ETF in this market. The iShares MSCI Korea UCITS ETF (LSE: IKOR) does exactly what it says on the tin by tracking the MSCI Korea Index.
In Singapore most of the ETFs and funds are too small so I have opted for the First State Singapore and Malaysia Growth Fund, which is 57% invested in Singapore equities and 22% in Malaysia. Performance has been workmanlike but certainly does not justify the 1.5% management fee; nonetheless, the choices are few and the portfolio has some interesting positions.
In Japan I have previously recommended and continue to hold Baillie Gifford Shin Nippon (LSE: BGS), an investment trust with a tremendous and consistent record of steady, market-beating returns. Over the last five years the net asset value (NAV) has increased by a really impressive 220% , compared with a 55% rise by the MSCI Japan Smaller Companies Index.
The Jupiter European Opportunities Trust (LSE: JEO) has also done a great job over most time periods and its NAV over five years has risen by 83%. The FTSE World Europe ex-UK index has managed only a fraction of that: 9%. The main country weightings are Germany 21%, France 14% and the Netherlands 12%. There is also 16% in UK equitieswith significant exposure to Europe. It’s light on financials at 10%, which is something I wholly approve of.
UK investors are spoilt for choice in their home market but once again I suggest the Henderson Smaller Companies Investment Trust (LSE: HSL), which I continue to own. Over the last ten years the share price has seen a gain of 435%, the FTSE All Share Index had a “mere” 75% rise and the Numis Smaller Companies Index an even smaller one. Despite this stellar performance you can buy the trust today at a 7% discount to NAV. For exposure to both small and larger companies a good choice is the Finsbury Growth & Income Trust (LSE: FGT), which has enjoyed a gain of 320% over the past decade. It’s highly focused: the top-ten holdings account for 82% of assets.