How do you know when a market is cheap?

How do you make money investing? It’s deceptively simple. You just ‘buy low, sell high’ – invest when markets are cheap and sell when they’re expensive.

Trouble is – as you no doubt know already – that’s a lot easier said than done.

Assets that look cheap can often get a lot cheaper. Sometimes cheap-looking companies end up being worth nothing. And assets that look expensive often become a lot more expensive before they blow up. You only have to look at any bubble in history to see that.

However, there is a useful measure that can help you know when a market as a whole looks expensive or cheap. It’s not perfect – no measure is – but research suggests that it can certainly show when a market is ridiculously over- or under-valued.

We’re talking about the cyclically-adjusted price/earnings (CAPE) ratio, also known as the Shiller p/e (after its creator, Yale professor Robert Shiller).

Mean reversion matters

One thing we believe in at MoneyWeek is ‘mean reversion’. This is the idea that if markets become too over- or under-valued compared to their underlying fundamentals (things like earnings and dividend payouts), then eventually they will switch course and return to a more sensible valuation.

So a market that has been unfairly neglected will eventually have its place in the spotlight again. And one that has risen to bubble-like levels, will collapse back towards ‘fair’ value and probably overshoot on the way down.

So how do you tell if a market is cheap or expensive? This is one of the questions Shiller and his colleague John Campbell asked themselves during the 1990s tech bubble.

They found that one of the most reliable predictors of future stockmarket returns was the CAPE. What is the CAPE?

Well, we’ve already looked at the price/earnings ratio in this series. The standard p/e ratio simply divides the price of the market (the overall market capitalisation) by one year’s earnings. Under the normal p/e ratio, a low number is cheap, and a high number is expensive.

Trouble is, it doesn’t account for shifts in the business cycle. What do we mean by that? Well, when times are good and earnings are high, a market might look cheap compared to its price. But if the economy is about to collapse (and drag earnings down with it), then clearly it’s not a good time to invest.

The point of the CAPE is to make allowances for the business cycle – for the fact that there are ups and downs in the economy, basically. It takes annual earnings for the last ten years, then averages them. You then divide the current market capitalisation of the market (the ‘p’) by this average earnings number.

What this does is it ‘smoothes out’ changes in earnings that are due to the ups and downs of the economic cycle. As a result, you get a better picture of just how cheap or expensive a market is at any given time.

Evidence suggests the CAPE works

The point of the ordinary p/e ratio is that it just shows what investors are currently willing to pay for a given level of earnings. During or ahead of an economic upswing, they should arguably be willing to pay more, as earnings are likely to grow. And during or going into a downturn, they should pay less, as earnings may fall.

So if you ‘smooth out’ these cyclical earnings changes, you should get a roughly objective view of whether investors are currently paying a lot, or a little, for earnings compared to history.

If you agree that ‘it’s never different this time’ – that no magic economic wand has been waved that means you should be willing to pay much more (or less) for earnings now than you were ten or 20 years ago – then the CAPE should revert to a historical mean over time.

And broadly speaking, it does. Shiller and Campbell found that if you bought stocks when the CAPE was low, your returns over the next ten years would be high. The very best times to buy came when the CAPE fell below ten, though that hasn’t happened since the early 1980s.

If you bought when the CAPE was high – much above 20, roughly speaking – your returns over the next ten years would be low or negative.

When they published their findings at the turn of the century, the US stockmarket was trading at record highs, on a CAPE of more than 40.

Of course, it then collapsed as the tech bubble burst, proving their point.

Shiller’s results focused on the S&P 500, and it’s easy to find a regularly updated number for the Shiller p/e (here’s one website that does it).

A common complaint about the Shiller p/e is that the US market has very rarely been cheap enough to be considered a ‘bargain’, particularly in recent decades. It’s currently trading at above 20, compared to a long-term average of around 16.5.

But this only matters if you only buy US stocks. The fact is, the measure doesn’t just work in the US. More recent research by investors including Joachim Klement at Wellershoff & Partners, and Mebane Faber at Cambria Investment Management, suggests that CAPE works for most global stock markets, from developed stocks to emerging markets.

While it’s harder to find the CAPE for non-US markets, Faber does regular updates at his blog here. This means you can get a good idea of where the cheapest markets in the world are, based on this measure.

The good thing is that it’s very easy for British investors to get access to overseas markets through various London-listed exchange-traded funds these days. So if you see that some peripheral European market looks cheap on this basis, for example, then you can buy in.

Now, it’s important to understand that the CAPE is not for traders. Markets can take a long time to revert to the mean. However, if you have an investment view of five years or longer – and really, that’s the least you should have if you are investing in stocks – then the good news is that the CAPE is a good predictor of returns for periods longer than five years.

And that’s why we like it. You see, you can never know the future – no one can. All you can do is play the odds. And the odds are, if a market is dirt cheap based on CAPE, then it has priced in almost everything bad that can happen to it. That means things can only get better.

And that’s the point at which you want to buy a market, the point of maximum gloom – not when everyone is cheerful and optimistic again.

You can read more on the CAPE in this MoneyWeek cover story from August 2012.

• This article is taken from our beginner’s guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here
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