The Limits of CAPE Analysis for Global Market Rotation

The cyclically-adjusted price to earnings ratio, or “CAPE” ratio, is an extremely useful tool for valuation analysis as it has been shown to have a high explanatory power for market returns.  This has been demonstrated not just in the United States, but in many other world markets, too.

However, the CAPE ratio is not without its critics as its denominator is the last ten years of real earnings, which some argue is less than useful, since it is backward-looking, and includes periods like the financial crisis, thus “skewing” the series.  This is an argument of bulls today who argue that CAPE, which is currently at its highest level since the peak of the tech bubble, is distorted by the huge drop in earnings from the financial crisis of 2007-2009:

Nevertheless, the high CAPE ratio has some people wondering if the smart move is for investors to rotate out of “expensive” U.S. equities into “cheaper” foreign markets, with popular mentions being Europe and emerging markets.

A classic example of this strategy paying off is the bursting of the Japanese equity bubble subsequent to its peak in 1989-90, when the CAPE ratio for Japanese equities approached 80, a level U.S. stocks have never come close to touching.  In retrospect, the theory goes, investors then would have been better off bailing out of Japanese stocks in favor of lower-priced global stocks.  After all, U.S. stocks started off 1990 with a CAPE of less than 19, and over the next ten years, U.S. stocks (as gauged by the respective MSCI indices) went on to outperform Japanese stocks by an astounding 2,000 basis points annually over the next ten years.

While this sounds simple enough in theory, a deeper analysis paints a more complicated picture.  For one, Japanese stocks have traded at a premium to U.S. shares for most of the past few decades, with an average monthly CAPE ratio more 20 points higher than the U.S:

An investor in 1981 who based his allocation solely on the absolute levels for each country’s CAPE would have missed out on a more than 1,000 basis point annual advantage for Japanese shares to U.S. shares.  Granted, the Japanese market during this time was in the midst of one of history’s great equity bubbles, but there are several other examples from the recent past when abandoning seemingly expensive markets would have proved premature.

Consider the case of Sweden which, hit a Japan-like CAPE high of 79 in early 2000.  At the same time, the U.S. was also at its all-time high, but seemingly a relative bargain at just 47.  Since then through 2017, U.S. shares have indeed outperformed Swedish shares, but it would have taken the patience of saint to wait so long; despite the huge premium, MSCI Sweden outperformed the MSCI USA index by more than 240 basis points annually over the ten year period starting in March 2000 (highlighted area below):

Another example would be the case of Switzerland, which reached a peak CAPE of almost 60 in July of 1998, versus 40 for the U.S.  Despite the discount, U.S. shares trailed Swiss shares by 1.7% per year over the next ten years.

It bears repeating that currency plays a huge role in relative returns between two global markets.  In the case of 1980s Japan, the yen strengthened considerably against the dollar during the decade, somewhat turbocharging relative equity returns.  Similarly, the Swedish krona and the Swiss franc appreciated versus the dollar in the aftermath of the tech bust, helping Swedish and Swiss shares offset their rich valuation compared to the U.S.

So, while buying cheap global stocks is generally a good plan, it should be done with caution, as history shows mean reversion is obvious only in hindsight; in fact, expensive markets can and often do become considerably more expensive than we might think possible, while apparently “cheap” markets may not be the bargains they seem, especially if their currencies weaken.  The best bet, as usual, is to utilize many valuation methods to discern true value, to contextualize valuations not just historically but also fundamentally, and, of course, to diversify sufficiently so that long periods of poor returns are mitigated if not avoided.