Money and Finance

Andrew Smithers on using CAPE in international markets

Link to Part 1: The problem of Cape and non-US markets (part 1)

The cyclically adjusted price-earnings ratio (Cape) has become well known as a way of valuing the US equity market. Its moderate success in this role has led to the assumption that the same approach will be valid for other markets. Unfortunately this seems doubtful, as I will try to explain. I should warn readers that, despite trying to make my explanation as simple as possible, I have been unable to avoid raising some quite technical points.

Link to Part 2: Why the cyclically adjusted PE usually fails for non-US stock markets (part 2)

Cyclically adjusted price-earnings ratio (Cape) appears to be a valid way to measure the value of the US stock market, but this does not mean that it can sensibly be used for other indices. As I explained in a previous blogpost, Cape is only valid if it can pass two tests: first, that the real return on equities has been mean reverting; and second, that profit margins have also been mean reverting and have rotated quickly around their average.

Real returns on equities has been less strongly mean reverting in other markets than they had been in the US. This weakens the case for Cape in other major stock markets, but does not, I think, necessarily rule it out. Even if returns would otherwise have been mean reverting, they will not have been if countries had suffered unexpected and catastrophic losses, such as occurred in world wars. I had already explained in Growth and returns, another blogpost, that these losses were the probable explanation for the exceptionally low returns on equity investment in the first half of the 20th Century in countries such as Germany and Japan.

If this proviso is accepted, it means that the calculation of Cape should exclude pre-war years. As earnings per share (EPS) data are generally not available before second world war this is almost a help rather than a hindrance. Even using postwar data, however, it is clear that the failure of real returns to exhibit mean reversion in Japan means that Cape cannot sensibly be used to value Japanese equities.

This leaves the second test to be considered and, unfortunately, this suggests that, with the possible exception of the UK, Cape should not be used for non-US markets.

- Us Companies Keep Buying And Keep Borrowing - By Andrew Smithers
Link to: US companies keep buying and keep borrowing I wrote in an earlier blog that I would become more cautious about US equities if profit margins came down. We have just had the figures for the first quarter of 2014 and profit margins have narrowed....

- John Mauldin: Forecast 2014: The Capes Of Hope
Link to: Forecast 2014: The CAPEs of HopeLast week's letter focused on my 2014 outlook for the US stock market and highlighted an important, but controversial, measure for long-term valuations: Robert Shiller's cyclically adjusted price-to-earnings...

- Gundlach Dips Toe Into Uber-indexing
DoubleLine Capital LP plans to launch an enhanced index fund based on Yale University economics professor Robert Shiller's cyclically adjusted price-earnings ratio. The DoubleLine Shiller Enhanced CAPE Fund will use derivatives — either swaps...

- Value Matters: Predictability Of Stock Index Returns
Found via World Beta. Abstract:The aim of this paper is twofold: to provide a theoretical framework and to give further empirical support to Shiller's test of the appropriateness of prices in the stock market based on the Cyclically Adjusted Price...

- Does The Shiller-pe Work In Emerging Markets?
Found via Mebane Faber. We test the reliability of the Cyclically Adjusted PE (CAPE) or Shiller PE as a forecasting and valuation tool for 35 countries including emerging markets. We find that the Shiller-PE is a reliable long-term valuation indicator...

Money and Finance