Editor’s note: This column is part of our “Best Stocks for 2013″ series; stay tuned for more entrants today, and check back tomorrow for a wrap-up of all the picks.
This piece is adapted from a longer white paper titled “Global Value: Building Trading Models with the 10 Year CAPE,” published in August 2012.
Benjamin Graham and David Dodd are universally seen as the fathers of valuation and security analysis. In their 1934 book Security Analysis, they were early pioneers in comparing stock prices with earnings smoothed across multiple years, preferably five to 10 years. Using backward-looking earnings allows the analyst to smooth out the business and economic cycle, as well as price fluctuations. This long-term perspective dampens the effects of expansions as well as recessions.
Robert Shiller, the author and Yale professor, popularized Graham and Dodd’s methods with his version of this cyclically adjusted price-to-earnings ratio (CAPE). His 1998 paper “Valuation Ratios and the Long-Run Stock Market Outlook” was shortly followed by his book Irrational Exuberance that included a warning on overvaluation prior to the 2000 stock market crash.
Shiller maintains a website with an Excel download that includes historical data with formulas illustrating how to construct his 10-year CAPE. Shiller has CAPE values going back to 1881 for the U.S. The long-term series spends about half of the time with values ranging between 10 and 20, with an average and median value of about 16. The all-time low reading was 5, reached at the end of 1920, and the high value of 45 was reached at, you guessed it, the end of 1999.
Since we could not find the data anywhere else, we constructed historical CAPE values for 32 countries, including as much data as we could find. We used local real returns (and found dollar-based real returns to be nearly identical) to net out the effects of inflation.
We found most CAPEs averaged around 15-20, bottomed out around 7, and maxed out around 45 (and a few made the U.S. bubble in the late 1990s look pathetic in comparison, like Japan reaching a value of nearly 100 in 1989).
So the big question: Do the extremes in valuations signal bubbles and generational buying opportunities?
We examined at the database for all instances where CAPEs were below 5 at the end of the year. We also included the longer U.S. and U.K. datasets here for some context. We only found nine out of about 850 total market years that fit the criteria: the U.S. in 1920; the U.K. in 1974; the Netherlands in 1981; South Korea in 1984, 1985 and 1997; Thailand in 2000; Ireland in 2008; and … Greece in 2011.
Can you imagine investing in any of these markets in those years? In every instance the news flow was horrendous and many of these countries were in total crisis.
But suppose you did invest in these seemingly deplorable markets, the literal worst of the most disgusting geopolitical headlines? Below are local country annualized real returns (net of inflation):
- 1-year: 35%
- 3-year: 30%
- 5-year: 20%
- 10-year: 12%
On the other hand, we identified only six countries that ever had the ignominious honor of ending the year with CAPE values over 50: Austria in 1991; Malaysia in 1993; Japan in 1986-1990, 1999, 2005, and 2006; Italy in 2000; and India and China in 2007. The internet bubble in the U.S. narrowly missed the mark with a value of 45 in December 1999. But wow, talk about a list of awful times to invest!
Below are local country real returns, on average:
- 1-year: -15%
- 3-year: -9%
- 5-year: -6%
- 10-year: -3%
The U.S. is currently trading at a value of around 21, which is historically expensive and falls in the 20-25 bucket, where future 10-year real returns are a meager 2.7%. However, as you can see below from the end of November 2012, many countries are trading at very low levels.
While we recommend that investors build portfolios that hold a handful of these country ETFs, this roundtable is focusing on just one idea, so we will go with the cheapest ETF — namely Greece, as tracked by the MSCI Greece Fund (NYSE:GREK). While the ETF is up a whopping 80% since bottoming out at $8.78, the MSCI Greece index is still down more than 80% from the peak.
We own GREK in client accounts and may buy more or sell the shares depending on our quantitative models.