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Figure 8 10-Year CAPE Levels And Future Average Real Compound Returns For 39 Countries 1980 – 2012 Avg CAPE By Bucket % Occurence 1-Year Real CAGR 3-Year Real CAGR 5-Year Real CAGR 7-Year Real CAGR 10-Year Real CAGR < 10 10.8% 23.3% 15.1% 17.6% 15.8% 12.3% 10 to 15 21.2% 24.8% 16.7% 14.0% 12.1% 9.1% 15 to 20 25.5% 13.1% 11.7% 10.8% 9.3% 8.8% 20 to 25 18.0% 8.6% 7.8% 6.5% 7.5% 6.1% 25 to 30 10.5% 1.0% 2.6% 5.6% 5.4% 4.4% 30 to 40 7.4% 7.1% 1.0% 0.7% 2.6% 2.9% 40 to 50 4.6% -6.0% 0.8% 2.7% 1.5% 1.0% >50 1.9% -10.7% -11.7% -4.0% -1.5% -2.9% Sources: Global Financial Data, MSCI Figure 9 Portfolios Sorted On CAPE Levels With No Filters, Real Returns 1980-2011 Yearly Top 33% Yearly Top 25% Yearly Top 10% Strategy Sources: Global Financial Data, MSCI Eq Wt Cheapest Eq Wt Expensive Eq Wt Spread Eq Wt All CAGR 12.0% 8.2% 2.5% 9.8% Stdev 27% 26% 18% 25% Maxdd 54% 47% 59% 50% CAGR 12.3% 6.3% 4.5% 9.8% Stdev 27% 26% 20% 25% Maxdd 55% 48% 62% 50% CAGR 16.6% 6.0% 7.0% 9.8% Stdev 35% 29% 34% 25% Maxdd 59% 67% 81% 50% Figure 10 Portfolios Sorted On CAPE Levels With Filters, Real Returns (Max CAPE Of 15 For Long; Min CAPE Of 30 For Short), 1980-2011 Yearly Top 33% Yearly Top 25% Yearly Top 10% Strategy Sources: Global Financial Data, MSCI Eq Wt Cheapest Eq Wt Expensive Eq Wt Spread Eq Wt All CAGR 12.6% 0.4% 11.7% 9.8% Stdev 23% 12% 21% 25% Maxdd 20% 43% 27% 50% CAGR 13.3% 0.7% 12.0% 9.8% Stdev 23% 13% 21% 25% Maxdd 20% 45% 30% 50% CAGR 17.5% 1.5% 11.1% 9.8% Stdev 32% 27% 36% 25% Maxdd 32% 73% 81% 50% There is very little in the literature regarding global CAPEs for international equity markets. the start of these 10-year periods. The average valuation for the 10 best years was 10.92. The average valuation for the 10 worst years was 23.31, double that of the best starting points. Buy Low, Sell High Figure 3 is a table of all of CAPE year-end readings from 1881-2011. We list how often they occur, as well as the real forward returns. The red bar in Figure 4 is where we find ourselves as of the summer of 2012. What we find is no surprise: It very much matters what price one pays for an investment! Indeed, it is an almost perfect stair step: Future returns are lower when valuations are high, and future returns are higher when valuations are low. While more sophisticated models can be built, Figure 5 simply shows the shockingly similar trend lines of an inverse CAPE and future 10-year real stock returns. 3 Valuation And Inflation Besides general sentiment, what might cause this large variation in what multiples investors are willing to pay for stocks? After all, at a current value of around 1374, this means the S&P 500 could trade at either 315 or 2800 based on historical low and high multiples of 5 and 45, respectively. It is difficult for most investors to comprehend the possibility of stocks declining 80 percent or increasing over 100 percent, but both of these multiples have occurred in the past. One of the determinants of the valuation multiple investors are willing to pay is the inflation rate as seen in Figure 6. The red bar is where we find ourselves as of the summer of 2012. When inflation is in the 1-4 percent “comfort zone,” investors are willing to pay a valuation premium compared with when there is either high inflation or outright deflation. 4 Global CAPE There is very little in the literature regarding global CAPEs for international equity markets. 5 We examined 39 countries with data from MSCI and Global Financial Data, including as much data as we could find, although there is some bias in the study. All the returns are real dollar returns. Two countries had a century’s worth of data (U.S. and 20 March / April 2013
the U.K.), but most of the other countries go back to the 1970s and 1980s (see Figure 7). We examined all the countries on a yearly basis since 1980, CAPE levels and future returns. The sample includes approximately 10 countries in 1980, 20 in 1990 and 30 by 2000. The results are in Figure 8 and largely confirm the U.S. data: Buy low, sell high. We found most CAPEs averaged around 15-20, bottomed out around 7, and maxed out around 45 (a few made the U.S. bubble in the late 1990s look pathetic in comparison, as when Japan reached a value of nearly 100 in 1989). A Global Stock Trading System But can we turn this into a trading system? There is evidence that sorting countries on other measures of value works well. A good summary of the dividend literature can be found in the Tweedy, Browne paper titled “The High Dividend Return Advantage.” 6 In the paper, they summarize a 1991 study by Michael Keppler titled “The Importance of Dividend Yields in Country Selection“ 7 that found that ranking the universe of countries by dividend yield also resulted in outperformance. He found that the highest-yielding countries outperformed the lowest-yielding from 1969-1989 by more than 12 percentage points per year. Running a similar study using a different database (Global Financial Data), 8 we sorted countries by quartiles from 1920-2011, beginning with nine countries and expanding to 18 by study end. We found that countries in the highest-dividend-paying quartile outperformed the countries in the lowest-paying quartile by 11 percentage points per year. (Also see the Appendix for tests on book value, dividends, cash flow and earnings.) We then set out to test CAPE in a similar manner. Starting in 1980, we sort all countries by CAPE, and invest in the most undervalued x percent, rebalanced yearly. We also show the effects of investing in the most overvalued x percent, as well as a long/short portfolio. These returns are real returns net of inflation, and with yearly data (which will naturally understate drawdown figures). The sample includes approximately 10 countries in 1980, 20 in 1990 and 30 by 2000. Investing in the cheapest countries produces 2 to 7 percentage points of outperformance, while the overvalued countries underperform (see Figure 9). The spread is approximately similar to those appearing in the previously mentioned dividend studies, albeit slightly lower. However, investing in the cheapest countries on a relative basis does not protect the investor when all countries are expensive in a global equity bubble like 1999. We repeated the study, but only invested long if the country was below a CAPE of 15, and only short above a CAPE of 30. If the country does not qualify for the valuation filter, then that part of the portfolio sits in cash (although we do not receive any interest income in this test) (see Figure 10). For the most part, adding the absolute CAPE-level filter results in better performance with lower drawdowns. This is to be expected, as the portfolio could be sitting in 20, 50 or even 100 percent cash (as with 1999 or 2007). In this case, the returns are higher as well. As many investors look at Figure 11 25,600 12,800 6,400 3,200 1,600 800 400 200 100 Portfolios Sorted On CAPE Levels, Real Returns 1980 – 2011 50 1979 1983 1987 1991 1995 1999 2003 2007 ■ Cheapest 33% ■ Expensive 33% ■ Eq Wt ■ Cheapest 33% with flter Sources: Global Financial Data, MSCI Figure 12 Appendix Data: Cheapest X Percent Of Countries, 1975-2011 33% CAGR STD MaxDD 25% CAGR STD MaxDD 10% CAGR STD MaxDD Buy & Hold 12.7% 13.5% 15.6% 13.2% 14.3% 22% 24% 24% 25% 24% 47% 46% 50% 46% 49% Buy & Hold 12.7% 15.4% 14.3% 14.0% 14.9% 22% 25% 26% 25% 24% 47% 43% 61% 46% 46% Buy & Hold Book Yield Book Yield Book Yield Earnings Yield Earnings Yield Earnings Yield 12.7% 18.1% 16.4% 13.5% 12.9% 22% 29% 28% 34% 26% 47% 38% 54% 55% 48% Source: Global Financial Data, MSCI, Fama & French Cash Flow Yield Cash Flow Yield Cash Flow Yield Dividend Yield Dividend Yield Dividend Yield this table and salivate over the prospect of 15 percent real returns, recall Figure 7 and note that most of the cheapest countries fall in the troubled eurozone. How many investors have the stomach to invest in these countries with potential for the markets to get even cheaper? How many professional investors would be willing to bear the career risk associated with being potentially wrong in buying these markets? Figure 11 depicts the equity curves from taking the cheapest 33 percent of countries (also with filter), the most expensive 33 percent of countries and the equal-weight benchmark. Summary Warren Buffett famously said, “Price is what you pay. Value is what you get.” Over periods of years and decades, it is evident that an investor’s real return is heavily dependent on the price paid for the asset. Investors can use CAPE valuation as a guidecontinued on page 41 www.journalofindexes.com March / April 2013 21
Page 1 and 2: Plus an interview with Robert Mayna
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Page 5 and 6: McGRAW-HILL You can never have too
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Page 17 and 18: ficially drive up the price of copp
Page 19 and 20: Over 70 years ago, Benjamin Graham
Page 21: are high as they do when valuations
Page 25 and 26: JOI: But PERSI’s strategy does se
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Page 29 and 30: Figure 1 Main Index Providers And R
Page 31 and 32: Figure 5 Five Key Issues With Equit
Page 33 and 34: Figure 8 Important Issues When Sele
Page 35 and 36: indexes that do not rely on a buy-a
Page 37 and 38: Figure 13 Relative Risk of Alternat
Page 39 and 40: For example, in a recent paper, we
Page 41 and 42: value of the Maximum Diversificatio
Page 43 and 44: Despite high t-statistics, statisti
Page 45 and 46: There is a growing body of research
Page 47 and 48: olling annual correlation to the re
Page 49 and 50: Interest rates go up. And down. And
Page 51 and 52: Figure 4 Impact Of Worst-Case Bond
Page 53 and 54: conference schedule the world’s b
Page 55 and 56: While the global financial crisis t
Page 57 and 58: [Kapadia & Szado, 2007] and reached
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Page 65 and 66: News continued from page 15 Malkiel
Page 67 and 68: ETF Analytics There are over 1,000

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